Stocks Like Rate Cuts
The big story this week was the Fed cutting interest rates for the first time since March 2020. We will get into all of the ramifications of the Fed’s decision below, but to kick off this week’s market commentary we will discuss why rate cuts can indeed be a bullish development for investors.
First things first, why are they cutting? If they are cutting due to a panic (think March 2020) or due to a recession (like in 2001 or 2007) potential trouble could indeed be lurking. But as we’ve been writing all year, we do not see a recession coming and with inflation back to manageable levels, there was simply no reason to have interest rates up over 5%. This is what we call a normalization cut, which historically has led to continued higher prices.
Here’s a table we put together earlier this year that shows a year after the first cut in a cycle, stocks were higher a year later eight out of 10 times and up a solid 8.0% on average. Yes, 2001 and 2007 are in there, as you’ve probably heard many times the past week if you’ve watched financial media at all. But we think now is more like the normalization cuts we saw in 1984, 1995, and 2019, all of which saw continued gains a year later.
Are rate cuts near all-time highs normal? It turns out they are and the last time we saw this was in 2019. We found 20 times the Fed cut interest rates without 2% of new all-time highs and wouldn’t you know it, a year later stocks were higher all 20 times. There’s an old saying not to fight the Fed and this is what they mean.
The S&P 500 jumped 1.7% on Thursday after the rate cut, so this might be early, but it is most definitely off to a nice start. Matching the 13.9% gain on average a year later would be something we think most investors would be quite happy with right now.
Here’s a nice chart showing all of the data.
Let’s Not Get Too Excited Yet
Yes, stocks hit new highs across the board last week on optimism about an economy that would likely avoid a recession and a Fed that was now cutting rates. We’d like to remind investors that the S&P 500 has closed higher nine of the past 10 months and it’s now higher in the normally weak month of September. But it is late September when trouble tends to hit, so we are right in that area where we could slip on the banana peel. Then don’t forget that no month is worse during an election year than October, as pre-election jitters can be quite real and something we aren’t ruling out for this year.
Here’s Why Markets Liked What the Fed Did and Hit a New Record High
Stocks reacted in a fairly neutral way after the Federal Reserve’s historically significant decision to jumpstart the rate cutting cycle with a 0.5%-point cut. But the real follow-through came on the day after the Fed meeting, perhaps after everyone slept on it. The S&P 500 surged 1.7% to close at a new record high on Thursday, September 19 (the first since July 16). That put the index up over 20% for the year. But wait, wasn’t the equity market supposed to move lower, not higher, in response to a large cut, on the assumption that it meant a recession was looming?
On top of that, Treasury yields for maturities over two years are now higher than they were relative to the day prior to the Fed meeting. If the Fed signaled a more dovish path for policy rates, why weren’t longer-term yields moving lower, not higher?
There’s No Puzzle: It’s About the Fed Supporting the Economy
The key takeaway from the Fed meeting was that they are not willing to tolerate the unemployment rate moving much higher — their projections put the unemployment rate at 4.4% (it’s currently at 4.2%). The Fed’s essentially putting a floor under the labor market.
Unlike in prior rate cutting cycles, the big rate cut wasn’t a “panic cut.” Safe to say we’re not in the middle of a recession, nor is one imminent over the next few months. Amongst other things, the August retail sales report showed that online sales grew at an annualized pace of 15% over the past three months. Layoffs are also relatively low. But Fed Chair Powell said the time to support the labor market is when it’s strong, not when you begin to see layoffs. In other words, the large cut was about risk management, with the Fed looking to get ahead of deteriorating labor market data.
The good news is that the Fed has room to support the labor market because inflation has eased a lot. An underrated factor here is lower energy prices. Beyond headline inflation, higher energy prices can even feed into core inflation numbers that the Fed typically focuses on. For example, higher energy prices can raise restaurant prices and airfares. We’ve gotten a break there, with WTI oil prices pulling back by about 17% since early April.
All this is very positive for the economy. And if economic growth remains resilient, bond yields should not be moving lower. On the other hand, if investors didn’t believe the Fed and thought they were behind the curve, we’d likely have seen bond yields fall, as investors priced in a higher risk of recession. For now, investors appear to be taking the Fed’s word that they’re putting a floor under the labor market, and therefore the economy.
Equity markets have been reflecting this since last week, after a Wall Street Journal report published on September 12 suggested the Fed was considering a big cut. The massive rally on Thursday capped what was already happening. From September 11 through September 19, the S&P 500 rose 3%. But mid- and small-cap stocks, which are even more geared to economic growth, outperformed. The Russell Mid Cap index rose over 4% during this period, while the Russell 2000 small cap index rose over 7%. These still lag their large cap counterparts substantially year to date, but we believe there’s potentially more follow-through to come, especially with the Fed backstopping the economy. Full disclosure: we’re overweight these areas of the equity market in our model portfolios. Economic growth is what you need for profit growth, and that’s what drives returns. The new record is not a “sugar high” by any means.
We also saw this story of stronger economic growth expectations playing out within large-cap sectors. Cyclical sectors, including energy, communications, industrials, consumer discretionary, materials, and financials all outperformed the broad index, whereas more defensive sectors like consumer staples underperformed.
All that said, keep in mind that we could yet see some volatility over the next several weeks, but going forward, we have some strong tailwinds for markets (and the economy). If nothing else, momentum begets momentum. And we have a lot of that now.
This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
S&P 500 – A capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The NASDAQ 100 Index is a stock index of the 100 largest companies by market capitalization traded on NASDAQ Stock Market. The NASDAQ 100 Index includes publicly-traded companies from most sectors in the global economy, the major exception being financial services.
A diversified portfolio does not assure a profit or protect against loss in a declining market.
Compliance Case # 02419581_092324_C
