Wall Street’s Strong Performance Faces Critical Crossroads as Rates Shift

With only six trading days left in the year, Wall Street is closing out what many describe as an outstanding year. By the closing bell on December 18, the well-established Dow Jones Industrial Average (DJINDICES: ^DJI) gained 12%, the broad-based S&P 500 (SNPINDEX: ^GSPC) climbed 23%, and the innovation-driven Nasdaq Composite (NASDAQINDEX: ^IXIC) saw a remarkable 29% increase.

What Fueled This Year’s Stock Market Surge?

This impressive performance stems from a combination of key factors, including:

• The growth of artificial intelligence (AI), which is projected to be a $15.7 trillion market, according to PwC research.
• Anticipation surrounding stock splits from major companies.
• Corporate earnings that surpassed expectations.
• The impact of President-elect Donald Trump’s election, which historically boosted the Dow Jones, S&P 500, and Nasdaq Composite during his first term.

Despite the market’s success, warning signs are appearing that indicate stocks might be overvalued. Currently, the S&P 500’s Shiller price-to-earnings (P/E) ratio stands at one of its highest levels in 153 years.

Additionally, the Federal Reserve’s actions, such as rate-easing cycles, often serve as a warning to investors, showing potential risks ahead.

Image source: Getty Images.

Investors Should Exercise Caution

The role of the Federal Reserve is to foster economic growth while controlling inflation. To achieve this balance, it adjusts its monetary policy, including modifying the benchmark federal funds rate and engaging in open-market operations. This may sound complex, but the effects can be significant.

What’s particularly intriguing is how stock market behavior often contradicts expectations. For instance, when the Fed raises interest rates, the common assumption is that borrowing costs will curb corporate growth. Yet historically, major gains in the stock market have occurred during periods of rising interest rates when the Federal Reserve aims to control inflation.

Conversely, reducing interest rates might seem beneficial, encouraging borrowing. However, past data suggests that these rate cuts often follow signs of economic weakness.

Historical Context of Rate-Easing Cycles

Since the year 2000, the Federal Reserve initiated four rate-easing cycles, including the one currently underway. Each of the previous three was associated with significant declines in the S&P 500.

The first dovish shift began on January 3, 2001, with the Fed lowering rates from 6.5% to 1.75%. The S&P 500 took 645 days to discover its low point, during which it lost over 42% of its value.

^SPX data by YCharts. Return rate from Jan. 3, 2001-Oct. 9, 2022.

The second round of rate cuts started on September 18, 2007, just before the financial crisis. Over 15 months, rates were slashed from 5% to a historic low of 0% to 0.25%. This time, the S&P 500 took 538 days to hit its lowest point, shedding more than 55% of its value.

^SPX data by YCharts. Return rate from Sept. 18, 2007-March 9, 2009.

The third cycle began in July 2019, and due to the COVID-19 crisis, the Fed cut rates rapidly from 2.25% to 0% to 0.25%. Following this reduction, the S&P 500 dropped nearly 25% over the following 236 days.

^SPX data by YCharts. Return rate from July 31, 2019-March 23, 2020.

Notably, recessions followed each of these rate cuts. Historical trends suggest that approximately two-thirds of significant declines in the S&P 500 since 1927 occurred during a recession.

In summary, rate-easing periods have typically been detrimental to the stock market in the 21st century.

Image source: Getty Images.

Finding Hope in Uncertain Times

While the historical patterns may seem ominous, they can also offer some comfort to long-term investors. Economic contractions and stock market downturns are natural parts of financial cycles.

The U.S. economy has experienced 12 recessions since World War II ended in 1945. Despite these challenges, the economy and stock markets eventually find a way to recover.