By Lewis Krauskopf
NEW YORK (Reuters) – As the Federal Reserve begins a long-awaited cycle of rate cuts, some investors fear the benefits of looser monetary policy have already been priced into highly valued U.S. stocks, making it harder for markets to rise further.
Investors cheered the first rate cuts in more than four years on Thursday, with the S&P 500 hitting new records a day after the Fed cut borrowing costs by as much as 50 basis points to support the economy.
History supports such bullishness, especially if the Fed’s assurances about a still-healthy U.S. economy pan out. The S&P 500 has risen an average of 18% per year after the first rate cut in an easing cycle, as long as the economy avoids a recession, according to Evercore ISI data since 1970.
But stock valuations have risen in recent months as investors expecting Fed cuts have flocked to stocks and other assets seen as benefiting from looser monetary policy. As a result, the S&P 500 has traded at more than 21 times forward earnings, well above its long-term average of 15.7 times. The index has risen 20% this year, even as U.S. job growth has been weaker than expected in recent months.
As a result, the short-term “upside from just lower rates is somewhat limited,” said Robert Pavlik, senior portfolio manager at Dakota Wealth Management. “People just get a little nervous when they go up 20% in an environment where the economy has cooled.”
Other valuation measures, including price-to-book and price-to-sales, also show stocks trading well above their historical averages, analysts at Societe Generale said in a note. U.S. stocks, for example, are trading at five times book value, compared with a long-term average of 2.6.
“Current levels can be summed up in one word: expensive,” SocGen said.
Lower interest rates can help stocks in several ways. Lower borrowing costs are expected to increase economic activity, which can boost corporate profits.
A fall in interest rates also reduces yields on cash and fixed income, making them less competitive with stocks. The yield on the benchmark 10-year Treasury note has fallen by about a full percentage point since April, to 3.7%, though it rose this week.
Lower rates also mean that future corporate cash flows are more attractive, which often pushes up valuations. But the S&P 500’s price-to-earnings ratio has already recovered significantly from 15.3 at the end of 2022 and 17.3 at the end of 2023, according to LSEG Datastream.
“Equity valuations were pretty good when we started this,” said Matthew Miskin, co-chief investment strategist at John Hancock Investment Management. “It’s going to be tough to replicate the multiple expansion that you’ve had over the last two years over the next couple of years.”
Miskin and others said further increases in valuations are expected to be limited and that earnings and economic growth will be the main drivers of the stock market. According to LSEG IBES, the S&P 500 is expected to rise 10.1% in 2024 and another 15% next year, with the third-quarter earnings season starting next month and testing valuations.
At the same time, there are signs that the promise of lower rates has already attracted investors. While the S&P 500 is typically flat in the 12 months leading up to rate-cut cycles, it has risen nearly 27% this time around, said Jim Reid, head of macro and thematic research at Deutsche Bank, who has studied data since 1957.
“It could be argued that some of the potential gains from a ‘no recession-easing cycle’ have been borrowed from the future this time around,” Reid said in the note.
It is true that many investors are not deterred by the high valuations and remain positive about equities.
Valuations are often a poor tool for determining when to buy and sell stocks, especially since momentum can send markets soaring or falling for months before returning to their historical averages. The forward P/E ratio for the S&P 500 has been above 22 times in 2020 and 2021, and has topped 25 during the dotcom bubble in 1999.
Meanwhile, rate cuts near market highs often 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 each time a year later, with an average gain of 13.9%, Detrick said.
“Historically, equity markets have done well during periods when the Fed has cut rates while the U.S. economy is not in recession,” analysts at UBS Global Wealth Management said in a note. “We expect this to be no exception.”
(Reporting by Lewis Krauskopf in New York; Editing by Ira Iosebashvili and Matthew Lewis)
