History says the stock market will make a big move now that interest rates are falling

The Federal Reserve is charged with maintaining stable prices and maximum employment. Adjusting the target range of the federal funds rate is a tool used by policymakers to achieve this goal. The federal funds rate is a benchmark that influences other interest rates in the economy. Higher rates discourage borrowing and slow the economy, and lower rates do the opposite.

In 2022, the Fed began an aggressive rate-hike cycle to reduce the runaway inflation indirectly triggered by the pandemic. Policymakers ultimately pushed the benchmark rate to its highest level in two decades. However, they reversed their stance in September 2024 in response to falling inflation and a tightening labor market.

The Fed announced a half percentage point interest rate cut on September 18, marking the first cut of 2020. S&P 500 (^GSPC 0.40%) it’s already up about 2% on the news, but history says the stock market could move much higher in the year ahead.

The S&P 500 tends to produce positive returns when cutting cycles begin

Since 1984, the Federal Reserve has steered the economy through 11 rate-cutting cycles. The table shows how the S&P 500 has performed in the 12 months following the initial cut in the federal funds rate in each cycle. Importantly, the index produced a positive one-year return nine out of 11 times.

Data source: Trading Economics.

As shown, since 1984 the S&P 500 has returned an average of 14% in the one-year period following the first rate cut in a cutting cycle. This model makes sense. Cheaper credit encourages consumer spending and business investment, which should lead to strong financial results and stock market appreciation.

That said, how the stock market performs after the onset of a bearish cycle has historically been linked to whether the economy avoids a recession. Specifically, a recession occurred no more than 12 months after the three cutting cycles that began in 2001, 2007, and 2019. The S&P 500 fell an average of 14% in the year following the onset of these cycles .

By comparison, the economy has not experienced a recession within 12 months of the other eight cutting cycles, and the S&P 500 has averaged a one-year return of 18%. This bodes well for investors. Economist surveyed by The Wall Street Journal in July it estimated the probability of a recession within 12 months at 28%, the lowest reading in more than two years.

In addition, analysts from Goldman Sachs recently weighed in, saying, “With recession risk now low and the Fed’s move appearing to be policy normalization, we think stocks can continue to see positive momentum absent any severe economic deterioration.”

Investors should be cautious in the current market environment

While history says the S&P 500 could move higher over the next year, one argument against that outcome is its high valuation. The S&P 500 currently trades at 21.4 times forward earnings, a significant premium to its five-year average of 19.5 times forward earnings. That multiple means many stocks are expensive by historical standards, which could lead to a market correction at the first sign of trouble.

Additionally, the S&P 500 has a median year-end target of 5,600 based on aggregate estimates from 14 Wall Street analysts. This forecast implies a downside of almost 3% from the current level of 5,750. The highest target of 6,100 comes from BMO Capital Markets, while the lowest target of 4,200 comes from JPMorgan Chase.

With valuations high and analysts predicting the S&P 500 will decline in the coming months, investors should be cautious in the current market environment. That doesn’t mean avoiding stocks entirely, but rather being particularly picky about which stocks are worth buying.