On Thursday, investors celebrated the first rate cuts in over four years, propelling the S&P 500 to new record highs following the Fed's significant reduction of borrowing costs by 50 basis points aimed at bolstering the economy.
Historical trends lend credence to this optimism, particularly if the Fed's claims of a robust U.S. economy hold true. According to Evercore ISI data since 1970, the S&P 500 has averaged an 18% annual increase after the initial rate cut in an easing cycle, provided the economy avoids recession.
However, stock valuations have surged in recent months as investors, anticipating Fed cuts, have flocked to equities and other assets likely to benefit from looser monetary conditions.
Consequently, the S&P 500 is currently trading at over 21 times forward earnings, significantly above its long-term average of 15.7 times. Despite a 20% rise in the index this year, U.S. employment growth has fallen short of expectations in recent months.
Consequently, Robert Pavlik, senior portfolio manager at Dakota Wealth Management, noted that the immediate potential for gains from lower rates is somewhat constrained, as investors feel uneasy about a 20% increase in a cooling economic environment.
Additional valuation metrics, such as price-to-book and price-to-sales ratios, indicate that stocks are trading well above historical norms, with U.S. equities priced at five times their book value compared to a long-term average of 2.6. Societe Generale analysts summarized the current situation with one word: expensive.
Nevertheless, lower interest rates are expected to benefit stocks in various ways, as reduced borrowing costs could stimulate economic activity and enhance corporate earnings.
A reduction In interest rates also results in lower yields on cash and fixed income investments, making them less competitive with equities. Notably, the yield on the benchmark 10-year Treasury has decreased by approximately one percentage point since April, currently standing at 3.7%, though it has experienced a slight increase this week.
Furthermore, lower interest rates enhance the attractiveness of future corporate cash flows, often leading to an increase in valuations. However, it is worth noting that the P/E ratio for the S&P 500 has already rebounded significantly after reaching lows of 15.3 in late 2022 and 17.3 in late 2023, as per data from LSEG Datastream.
"Equity valuations were pretty reasonably full going into this," said Matthew Miskin, co-chief investment strategist at John Hancock Investment Management. "It's going to be hard to replicate the multiple expansion you just got over the last year or two over the next couple of years."
Valuations within the technology sector have surpassed their historical averages, largely due to significant stock price increases, particularly for companies like Nvidia, which has seen a rise of approximately 140% this year.
Currently, the tech sector is trading at around 28 times earnings, in contrast to a long-term average of 21, as reported by LSEG Datastream.
With expectations for further valuation increases being limited, experts like Miskin suggest that earnings and economic growth will play crucial roles in driving the stock market. Projections indicate that S&P 500 earnings are set to grow by 10.1% in 2024, followed by an additional 15% in the subsequent year, according to LSEG IBES.
The upcoming third-quarter earnings season, commencing next month, will serve as a critical test for these valuations. Additionally, there are indications that the prospect of lower interest rates may have already attracted investors.
Historically, the S&P 500 has remained relatively stable in the year leading up to rate-cutting cycles; however, it has increased by nearly 27% during this period this time, as noted by Jim Reid, Deutsche Bank's global head of macro and thematic research, who has analyzed data dating back to 1957.
"You could argue that some of a potential 'no recession easing cycle' gains have been borrowed from the future this time," Reid said in the note.
Many investors remain optimistic about stocks despite the high valuations. Valuations can be a challenging metric for deciding when to buy or sell stocks, particularly as market momentum can drive prices up or down for extended periods before they align with historical averages.
The forward price-to-earnings (P/E) ratio for the S&P 500 exceeded 22 for a significant portion of 2020 and 2021, peaking at 25 during the dotcom bubble in 1999. Additionally, interest rate cuts occurring near market peaks have historically been favorable for stocks a year later.
According to Ryan Detrick, chief market strategist at Carson Group, the Federal Reserve has implemented 20 rate cuts since 1980 when the S&P 500 was within 2% of its all-time high. In each instance, the index has shown an increase a year later, averaging a gain of 13.9%.
Historically, equity markets have performed well in periods when the Fed was cutting rates while the US economy was not in recession," UBS Global Wealth Management analysts said in a note. "We expect this time to be no exception."