The stock market has seemed to follow a broad pattern in recent months.
It looks something like this: Watch the Fed predict more rate cuts than expected.
Watch the market rise.
The momentum continued last week as the Federal Reserve stuck to its forecast of three rate cuts this year despite a worrying rise in inflation in January and February. The S&P 500 index has risen 1.1% since the Fed's announcement midday Wednesday and closed at 5,234 on Friday, just below the previous day's record high.
But the response to the financial rocket fuel of low interest rates is a little more nuanced, analysts say. The outlook for the US economy and corporate profits has brightened significantly in recent months. Investors like this narrative even more than low interest rates.
“I think the market is more focused on earnings and the economy than the Fed,” said Chris Zaccarelli, chief investment officer at the Independent Advisor Alliance.
And that means the market's recovery since the fall could be gathering steam, a development that would further boost Americans' 401(k) balances and other investments this year, even after an already big surge.
“I think there’s more wiggle room,” Zaccarelli says.
Why is the stock market rising?
There's little doubt that the Fed's median estimate on Wednesday of three rate cuts in 2024 pushed stocks higher last week. After inflation surged earlier this year, many economists expected officials would scale back their forecast to two cuts to ensure consumer price increases remained subdued before sharply cutting interest rates. Fed Chairman Jerome Powell suggested that the price rise could be an outlier and officials will closely monitor the data in the coming months.
But Fed officials also predicted last week that the economy will grow 2.1% this year, compared with a robust 3.1% in 2023 but well above their forecast of 1.4% in December. Consumer spending and job growth were surprisingly resilient despite high borrowing costs and prices, largely due to strong wage increases. The Fed's more optimistic assessment has also pushed up stock values, says Zaccarelli.
What is the company's profit forecast for 2024?
Meanwhile, earnings for S&P 500 companies are expected to rise 10.9% in 2024, according to FactSet. That's up from low single-digit gains last year, a jump driven in part by resolving pandemic-related supply chain issues and faster growth in productivity, or output per worker, said Ryan Detrick, chief marketing strategist at Carson Group. an investment firm.
On the surface, it might seem like the stock market is all about the Fed and interest rates. Wall Street welcomes lower borrowing costs for consumers and businesses because they encourage faster growth, which should boost corporate profits. Lower interest rates also encourage investors to shift money from bonds, which now pay lower yields, to stocks with higher returns.
Last fall, as inflation eased significantly, stock prices rose, largely in anticipation of faster rate cuts from the Fed. The rally gained momentum when the Fed raised its 2024 forecast from two to three rate cuts in mid-December. The S&P 500 index has risen 26.6% since the inflation slowdown began and is up 10.3% this year.
But even in February and March, when a key inflation indicator, the consumer price index, saw price increases accelerate in the first two months of the year, the S&P 500 largely shrugged off concerns and continued its upward trend.
Is the US in for a soft landing?
Sure, the Fed's interest rate forecasts are having an impact. But Detrick called it “the icing on the cake” of an improved economic and earnings situation. There is growing belief among forecasters that the Fed will achieve a “soft landing” in which it tackles high inflation without triggering a recession.
Put another way, if the Fed ends up cutting rates six times instead of three times as some economists expect, that means the economy is faltering or in recession, “and the stock market is going to go down,” Zaccarelli says.
Overall, however, the prospect of a solid economy and steady interest rate cuts is unusual and makes for a favorable environment for investors.
What causes interest rates to rise?
Traditionally, the Fed raises interest rates to curb inflation by increasing the cost of borrowing for consumers and businesses, thereby restricting economic activity.
From March 2022 to July 2023, the central bank raised its key interest rate from near zero to a 23-year high of 5.25% to 5.5%. The annual inflation rate reached a four-decade high of 9.1% in mid-2022 due to COVID-related product and labor shortages, but has since fallen to about 3%. That's still above the Fed's 2% target.
Why is the Fed cutting interest rates?
The Fed typically cuts interest rates to stimulate a struggling economy or pull it out of a recession. But lower interest rates probably wouldn't do much for stocks if the economy and corporate profits collapsed, Detrick and Zaccarelli say.
Now, however, the Fed plans to cut interest rates, not to stimulate the economy, but to bring interest rates closer to their long-term average as inflation returns to near normal. Otherwise, inflation-adjusted interest rates would slow the economy more than necessary.
Since 1984, when the Fed cut interest rates to bring them back to normal after a series of rate hikes, the S&P 500 index has risen an average of 13.2% in the following 12 months, according to Detrick's analysis.
On the other hand, when the central bank cuts interest rates to avert or save the economy from a downturn, the benchmark stock index falls by an average of 11.6% over the following 12 months.
Is investing in stocks a bad idea right now?
Despite the positive environment, significant risks remain for investors.
“The biggest risk is that the Fed keeps interest rates too high for too long” and the economy slips into recession, Zaccarelli says.
Additionally, share prices are at an all-time high of 20.9 times expected earnings over the next 12 months, according to FactSet. In comparison, the five-year average earnings multiple is 19 and the 10-year average is 17.7. In other words, stocks are expensive and could be facing a correction.
However, Detrick notes that prices in the late 1990s were 35 to 40 times earnings, adding: “Valuations are high, but not astronomically high.”
After setting an all-time record in January 2022, the S&P index experienced a sell-off due to skyrocketing inflation and Fed rate hikes and only returned to and surpassed that peak last January, suggesting stocks are still catching up for lost time.
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In a note to clients, Ned Davis Research said high valuations would not be a hindrance to the rally “as long as earnings growth remains strong.”
Detrick thinks the market could rise another 5% to 8% this year, but he avoids shares of Big Tech companies in favor of small-cap stocks that have suffered the most from high interest rates and are facing one recovery.
Zaccarelli said another 10% rise in the broad index is feasible as long as the economy doesn't fall into recession.
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