By Lewis Krauskopf
NEW YORK (Reuters) – As the Federal Reserve begins a long-awaited cycle of rate cuts, some investors fear that highly valued U.S. stocks have already priced in the benefits of looser monetary policy, making it difficult for markets to rise much higher.
Investors cheered the first rate cuts in more than four years on Thursday, sending the S&P 500 to new records a day after the Fed cut borrowing costs by a hefty 50 basis points to shore up the economy.
History supports this optimism, especially if the Federal Reserve's promises that the U.S. economy remains healthy are fulfilled. The S&P 500 has gained 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 data going back to 1970.
Yet equity valuations have risen in recent months as investors anticipating Fed cuts pounced on stocks and other assets seen as benefiting from looser monetary policy. That has left the S&P 500 trading at more than 21 times forward earnings, well above its long-term average of 15.7 times. The index is up 20% this year, even as U.S. job growth has been weaker than expected in recent months.
As a result, the “short-term upside that comes from lower rates is somewhat limited,” said Robert Pavlik, senior portfolio manager at Dakota Wealth Management. “People get a little nervous about a 20% hike in an environment where the economy has cooled.”
Other valuation indicators, such as price-to-book and price-to-sales ratios, also show stocks are well above their historical averages, Societe Generale analysts said in a note. U.S. stocks are trading at five times their book value, for example, compared with a long-term average of 2.6.
“Current levels can be summed up in one word: expensive,” SocGen said.
Lower rates can help stocks in several ways. Lower borrowing costs are expected to boost economic activity, which can strengthen corporate earnings.
A drop in rates also reduces yields on cash and fixed income, making them less competitive with stocks. The yield on benchmark 10-year Treasury bonds has fallen about a percentage point since April, to 3.7%, though it has edged up slightly this week.
Lower rates also mean future corporate cash flows are more attractive, which often boosts valuations. But the S&P 500’s price-to-earnings ratio has already recovered substantially after falling as low as 15.3 at the end of 2022 and 17.3 at the end of 2023, according to LSEG Datastream.
“Equity valuations were pretty good before this,” said Matthew Miskin, co-chief investment strategist at John Hancock Investment Management. “It's going to be difficult to replicate in the next few years the multiple expansion that was achieved in the last year or two.”
Miskin and others said that with any further rise in valuation expected to be limited, earnings and economic growth will be the main drivers of the stock market. S&P 500 earnings are expected to rise 10.1% in 2024 and another 15% next year, according to LSEG IBES, and the third-quarter earnings season that begins next month will test valuations.
At the same time, there are signs that the promise of lower rates may have already enticed investors. While the S&P 500 has tended to hold steady in the 12 months leading up to rate-cutting cycles, it is up nearly 27% in that period this time, according to Jim Reid, global head of macro and thematic research at Deutsche Bank, who has studied data going back to 1957.
“It could be argued that this time around some of the potential gains from a 'non-recession cycle' have been borrowed from the future,” Reid said in the note.
To be sure, many investors are undeterred by lofty valuations and maintain a positive outlook on stocks.
Valuations are often a tricky tool to navigate when determining when to buy and sell stocks, especially since momentum can send markets up or down for months before they return to their historical averages. The S&P 500’s forward price-to-earnings ratio was above 22 times for much of 2020 and 2021 and hit 25 times during the dot-com bubble in 1999.
Meanwhile, rate cuts near market highs tend to bode well for stocks a year later. The Fed has cut rates 20 times since 1980, when the S&P 500 was within 2% of an all-time high, according to Ryan Detrick, chief market strategist at Carson Group. The index has been higher a year later each time, with an average gain of 13.9%, Detrick said.
“Historically, equity markets have performed well in periods when the Federal Reserve cut rates while the U.S. economy was not in recession,” analysts at UBS Global Wealth Management said in a note. “We expect this time to be no exception.”
(Reporting by Lewis Krauskopf in New York; Editing by Ira Iosebashvili and Matthew Lewis)
