NEW YORK, Sept 20 (Askume) – As the Federal Reserve begins a long-awaited cycle of interest rate cuts, some investors worry that high-priced U.S. stocks have tasted the benefits of loose monetary policy, which would spell trouble for U.S. stocks.
Investors welcomed the first interest rate cut in more than four years on Thursday, pushing the S&P 500 (.SPX) to a new high a day after the Federal Reserve cut rates by 50 basis points to boost the economy .
History favors such a rebound, especially if the Federal Reserve’s assurances that the U.S. economy will remain healthy prove correct. Since 1970, the S&P 500 has risen an average of 18% annually following the first rate cut in an easing cycle, as long as the economy avoids recession, according to Evercore ISI.
But stock valuations have soared in recent months as investors hoping for rate cuts from the Federal Reserve have bought stocks and other assets that are seen to benefit from easy monetary policy. That puts the S&P 500’s forward price-to-earnings ratio at more than 21 times, well above the long-term average of 15.7 times. Although U.S. job growth has been slower than expected in recent months, the index is up about 20% this year.
As a result, “the benefit from low interest rates alone is somewhat limited” in the short term, said Robert Pavlik, senior portfolio manager at Dakota Wealth Management. “People are a little nervous about 20% growth in a cooling economy.”
Other valuation metrics, including price-to-book and price-to-sales ratios, also point to stocks trading above historical averages, Societe Generale analysts said in a note. For example, U.S. stocks trade at 5 times their book value, while the long-term average is 2.6 times.
“The current level can be described in one word: expensive,” Thorsgen said.
Low interest rates help the stock market in several ways. Lower borrowing costs are expected to boost economic activity, leading to higher corporate profits.
Falling interest rates also reduce returns on cash and fixed income, making them less competitive as equity investments. Despite rising this week, the benchmark 10-year Treasury yield has fallen by about one percentage point since April to 3.7%.
Lower interest rates also mean that future corporate cash flows will be more attractive, which will push valuations higher. But the S&P 500’s price-to-earnings ratio has improved sharply after falling to 15.3 at the end of 2022 and 17.3 at the end of 2023, according to LSEG Datastream.
“This time around, the stock’s valuation is fundamentally fair,” said Matthew Miskin, co-chief investment strategist at John Hancock Investment Management. “The multiyear expansion that has occurred over the last year or two will be hard to replicate in the years to come.”
Earnings and economic growth will be the stock market’s main drivers as valuations are expected to limit further upside, Miskin and others said. LSEG IBES expects S&P 500 earnings to grow 10.1% in 2024 and 15% next year, with the third-quarter earnings season starting to test valuations next month.
At the same time, there are signs that the promise of low interest rates has attracted investors. Jim Reid, global head of macro and thematic research at Deutsche Bank, who has been studying data since 1957, said the S&P 500 had been flat in the 12 months before the rate cut cycle, but this time it was % higher. It rose by about 27%.
“You could say that some of the benefits of this potential ‘recession-free cycle’ are borrowed from the future,” Reed said in the report.
Of course, many investors aren’t bothered by the high valuation and remain optimistic about the stock.
Valuation is a cumbersome tool for deciding when to buy and sell a stock, especially when momentum can keep the market up or down for months before returning to historical averages. The S&P 500’s forward P/E ratio was above 22x for most of 2020 and 2021, and peaked at 25x during the 1999 dot-com bubble .
Plus, a rate cut a year after the market hit a high bodes well for stocks. Ryan Detrick, chief market strategist at Carson Group, said the Fed has cut interest rates 20 times since 1980, when the S&P 500 was within 2% of its all-time high. The index has been rising year over year with an average growth rate of 13.9%, Detrick said.
“Historically, stocks have performed well when the Fed has cut interest rates and the U.S. economy has not fallen into recession,” analysts at UBS Global Wealth Management said in a note.
