Typically, significant cuts to the Federal Reserve’s interest rates paired with stock prices nearing historical highs tend to signal negative trends for the stock market.

Major rate reductions—like those endorsed by Federal Reserve officials last week—often indicate that the Fed is trying to steer the economy away from recession. High stock prices usually suggest that market gains are limited and may not have much potential for further growth.

However, the situation appears different this time.

Some analysts believe that the market is set to gain from a rare advantageous circumstance.

“The Fed is reducing rates while the economy remains strong,” noted Jeffrey Schulze, head of economic and market strategy at ClearBridge Investments. “This creates a powerful mix for potentially large market returns.”

On the other hand, at least one analyst suggests that the Fed’s significant actions last week highlight its concerns over a possible economic decline. Such a downturn would likely negatively affect stocks.

What Actions did the Fed Take on Interest Rates?

Recently, the Fed lowered its primary short-term interest rate by a noteworthy half a percentage point, marking its first cut in four years and exceeding many analysts’ expectations. They anticipate a total reduction of 2.25 percentage points by the end of next year and 2.75 points by 2026, bringing the benchmark rate down from around 5.4% to 2.9%.

It is well established that markets respond positively to Fed rate cuts, as they lower borrowing costs for both businesses and consumers, invigorating economic activity and enhancing corporate profits. Lower rates also motivate investors to move their funds from lower-yielding bonds into riskier stocks that offer potentially greater returns.

What Occurs in Markets During a Recession?

However, since 1984, whenever the central bank has reduced rates to jumpstart the economy during or in anticipation of a recession, the S&P 500 index has dropped an average of 11.6% in the year following the first cut, as revealed by Ryan Detrick, chief market strategist at Carson Group, an investment firm.

This indicates that the negative impact of a struggling economy on corporate profits outweighs any advantages offered by lower interest rates.

Conversely, when the Fed lowers rates to normalize them after a series of hikes, the S&P 500 tends to rise, averaging a 13.2% increase in the following year, according to Detrick’s analysis. This trend is a key reason why Fed officials are reducing rates now.

What Prompted the Fed to Raise Interest Rates Initially?

In 2022 and 2023, Fed officials increased the federal funds rate from near zero to curb economic activity and address inflation, which peaked at a 40-year high of 9.1% in mid-2022. As inflation has now fallen to nearly 3%, close to the Fed’s target of 2%, officials feel it is appropriate to start reducing rates.

Federal Reserve Chair Jerome Powell remarked last week that job growth has slowed significantly this year, yet reaffirmed that the economy and job market remain strong.

“The U.S. economy is in good shape,” Powell stated. “It’s expanding steadily, inflation is decreasing, and the labor market is robust. We aim to maintain this momentum by lowering rates before they stifle economic growth,” he explained.

Despite the Fed’s momentous action, the S&P 500 slightly dipped on Wednesday. This was partially due to investor concerns that the half-point cut might indicate Fed anxieties about a declining job market and economy, according to Detrick. Similar significant reductions previously occurred right before the recessions of 2001 and 2007-09, he noted.

This time, however, the Fed likely opted for a substantial cut simply to align itself following a pause in rate adjustments in July, Detrick indicated. Powell mentioned that officials may have cut rates in July had they received the weak job growth report that surfaced later.

The market reached record highs on Thursday after a report indicated that initial jobless claims—a reliable indicator of layoffs—had fallen to a four-month low, suggesting the economy is on stable ground. However, it gave back some of those gains on Friday, and stock prices may remain unpredictable in the typically weaker months of September and October, especially as the presidential election approaches, Detrick added.

What is the Current State of Our Economy?

While the unemployment rate rose from 3.7% to 4.2% this year, it remains relatively low historically. The economy expanded robustly at a 3% annual rate in the April-June period, with similar growth anticipated for the current quarter. Furthermore, recent notable increases in U.S. productivity, which measures output per worker, suggest further strong economic growth ahead, according to Detrick.

Analysts predict a solid corporate earnings growth of 10.2% this year, based on FactSet data.

“The Fed indicates that rates are currently excessive, and they are working to normalize them,” Detrick noted. “We are not heading toward a recession.”

What Impact Did the Pandemic Have on the Economy?

The Fed and the economy find themselves in a favorable position due to the unique dynamics stemming from the COVID-19 pandemic, Schulze from ClearBridge emphasized.

The Federal Reserve’s efforts to increase interest rates in order to control inflation have managed to slow spending and economic growth without triggering a recession, as stated by Schulze. He noted that inflation has decreased relatively quickly as the supply chain issues and shortages related to the pandemic have been resolved. This situation, he argued, paves the way for substantial and market-favorable reductions in interest rates without a high chance of recession.

In the 1990s, there were two instances when the Fed reduced its key interest rate by 0.75 percentage points, but Schulze described those moves as mere “tinkering,” unlike the more substantial reductions we see today.

Is the US stock market overpriced?

When looking at historical data, it appears that the stock market is indeed overpriced. Stocks in the S&P 500 are currently valued at 20.9 times their expected earnings per share over the next year. This is higher than the five-year average of 19.4 and the ten-year average of 18, as per FactSet statistics.

However, Detrick pointed out that high valuations have not prevented substantial market gains, provided the economy and corporate earnings remain strong. Since 1980, in the 20 occasions where the Fed began to lower interest rates while the S&P 500 was within 2% of its peak, the index saw an average increase of 13.9% in the next year, according to Detrick’s research.

“High valuations aren’t a reliable indicator for market timing,” he emphasized.

After gaining 24% last year and rising 19.4% so far this year, Detrick believes the benchmark index could see an additional 15% increase by the end of 2025.

What is the main threat to the economy?

There are differing opinions among experts. Recently, established economist David Rosenberg, president of Rosenberg Research, noted the significant weakness across many sectors of the economy, including housing, commercial construction, and the industrial sector, which he claims are all in recession.

Rosenberg continues to predict an economic downturn that could present challenges for stocks while making bonds more appealing. He believes that the Fed should have started to lower interest rates sooner, just as it should have increased them earlier to avoid the rise in inflation.

“The Fed is just as much behind the curve on growth as it was on inflation two years ago,” he remarked.