As advisors obsess over when the Fed will start cutting the federal funds rate, there’s precious little focus on the actual impact lower interest rates will likely have on the stock market.
Many advisors seem to be assuming that lower rates will magically transport the market to Valhalla and keep it there indefinitely. But just how much of a positive impact should really be expected, and for how long?
Sure, a lower cost of money is generally a good thing for most corporations, and lower rates naturally improve the outcomes of capital asset pricing model calculations for various equities—especially the high-valuation, rate-sensitive tech stocks.
But the impact of rates cuts on the market may not be as rosy as many advisors expect.
History offers some noncommittal clues to how long the market might run before declining after the first Fed cut.
Out of the last eight post-first-cut periods over the past 50 years, three were marked by near-term corrections, to be expected in growing markets. In the other five, the longest period until the S&P 500 hit a cycle low was about 450 trading days and the shortest, a few days. The average was 195 days.
Better Than It Looks
This might be a disappointingly brief period for advisors now expecting to reap equity gains for clients for much longer. Yet this number is cursed by the tyranny of averages, which usually don’t represent anything that actually happened, just an arithmetic, often misleading synthesis of things that did.
The same is true of the average decline of the S&P 500—a loss of 23.5%.
This average decline after rate cuts is skewed deeper, and the 195-day average period for a new low is skewed shorter, by the statistical impacts of recessions, the force majeure of market conditions. In this century, market declines of more than 20%, coincident with the onset of recessions, occurred in 1974, 2001, 2007 (the financial crisis) and 2020 (the pandemic).
Over the past few months, the widely presumed likelihood of a near-term recession has disappeared from many a radar screen.
For these individuals, when applying historical templates to the next post-cut period, it’s reasonable to expect good post-first-cut market performance for 12 months or possibly longer—if economic growth doesn’t slow significantly and that corporate earnings are decent.
The market’s anticipation of rate cuts was naturally a driver of equity performance until the middle of this month, before the market pullback.
High-Rate Plateau
We’re currently in a high-rate plateau—the period between a series of interest rate increases (the last of which came in July) and a series of cuts, which will begin God only knows when.
Coinciding with various positive factors, including persistent economic growth and historically high employment (paradoxically, positive things that many Fed watchers have come to fear), the current rate plateau has been quite positive for major indexes, hitting new highs, pre-pullback.
This is consistent with market history. Past high-rate plateaus have coincided with periods of substantially high returns for some equity categories.
Annualized returns in the first half of these plateaus have been much better than in the second half. Small-caps have posted high average gains in the first half of high-rate plateaus—28%—but only 4% in the second half. Growth stocks have returned 26% in the first half and 10% in the second; large-caps, 29% and 7%; value stocks, 19% and 4%; REITs, 14% and 4%; internationals, 12% and -2%; and emerging markets, 20% and -3%.
The first-half/second-half disparity naturally prompts the question: Which half of the rate plateau are we currently in? Of course, the only way to know this now is to know when rate cuts will begin.
With the Fed following its higher-for-longer mantra and inflation numbers showing some stickiness in recent months, expectations of the timing of a first cut are moving further down the road.
Already, sticky inflation data has pushed earlier expectations for a March cut back to June or later, and some economists now think the first cut won’t come until the fall (if at all this year).
Potential Fed Dilemma
Yet, there may be a problem with cutting in the fall—the election. While the Fed may not be political, it definitely doesn’t want to appear that way. This is kind of a Catch-22, as bending over backward to show a lack of influence shows a kind of influence.
“It may turn out that the data strongly argue for a rate cut in September,” said Mark Zandi, chief economist with Moody’s Analytics. “But the election’s in November. We know this is going to be a closely contested race. Does the Fed really want to get wrapped up in all of that? Probably not.”
So, in the absence of data screaming “cut” this summer—when the two parties’ nominating conventions will be held (in July and August)—the Fed might wait until after the election. This prospect assumes that employment remains high (one Fed mandate) and inflation is still declining (the other), however haltingly.
Regardless, presidential election years are usually positive for the market, and always when an incumbent is running. Since 1952, the S&P 500 has never been negative in a year when a president was seeking re-election. This invokes a scenario in which the incumbent administration uses the levers of power to gild the lilies of the economy. And currently, these lilies are growing on a high-rate plateau.
For those focusing on the market’s historical performance in the first half of high-rate plateaus—and counting months since the last rate hike in July—it’s becoming increasingly plausible to believe that we may still be in the first half. Yet, this time around, the market’s growing impatience in waiting for Fed cuts may make it overly optimistic to expect the normally likely plateau benefits to continue indefinitely.
Black Swan Caveat
Moreover, savoring the plateau’s protraction assumes that market history will repeat. But sometimes it doesn’t even rhyme.
Further, an especially thick veneer of caution should probably be added when overlaying historical templates on the current market.
Over the past few years, many historically based projections have been sabotaged by the persistent economic aftermath of the pandemic—the same pandemic that led to supply shocks, inflation and rate increases. As Fed Chairman Jerome Powell said at a recent press conference, “the pandemic is still writing the story of our economy.”
The recent pandemic occurred a century after the Spanish flu pandemic of 1918-1920, so the latter doesn’t offer a valid historical template, having occurred in far different economy.
And as Black Swan events are unique by definition, they defy historical comparisons.
Dave Sheaff Gilreath, CFP, is a founding principal and CIO of Sheaff Brock Investment Advisors, an investment firm for individual investors, and Innovative Portfolios, an institutional money management firm. Based in Indianapolis, the firms manage assets of about $1.4 billion. The investments mentioned in this article may be held by those firms, Innovative Portfolios’ ETFs, affiliates or related persons. There may be a conflict of interest in that the parties may have a vested interest in these investments and the statements made about them.