This stock market index has been 82% accurate since 1984. It signals big gains for the S&P 500. | The Motley Fool

The pandemic triggered the worst inflation in 40 years, and the Federal Reserve responded with its most aggressive interest rate hiking cycle in decades. Between March 2022 and July 2023, policymakers raised the federal funds rate to its highest level since 2001.

The federal funds rate is a benchmark that influences other interest rates across the economy, including interest rates on credit cards and loans. Higher interest rates discourage consumer spending and business investment, keeping price pressures in check. For example, the Fed’s rate-raising campaign has helped drop inflation by more than 6 percentage points since it peaked two years ago.

But rising interest rates also suppress economic growth. Recent reports have shown the labor market weakening and manufacturing activity shrinking. Based on these signals, investors are expecting the Federal Reserve to cut interest rates at its September meeting, but policymakers have not cut rates since 2020.

in fact, CME GroupThe Fed’s FedWatch tool, which uses price data from the futures market to forecast interest rates, gives a 100% chance of a rate cut in September, which bodes well for the stock market. S&P 500 (^GSPC -1.77%) Historically, the first rate cut of the cycle has been followed by positive returns in the 12 months since.

History suggests the S&P 500 could surge if the Federal Reserve starts cutting interest rates.

The Federal Reserve has pivoted from hiking to cutting interest rates 11 times in the past 40 years. After the first cut of each cycle, the S&P 500 posted positive 12-month returns 9 times out of 11. In other words, this particular stock market prediction tool has been 82% accurate since 1984.

The chart below shows how the S&P 500 performed in the 12 months following the first rate cut of each easing cycle, the period when interest rates were falling.

Data source: Trading Economics.

As shown above, since 1984, the S&P 500 has returned an average of 14% in the 12 months following the first rate cut of an easing cycle. This makes sense: lower borrowing costs should spur consumer spending and business investment, leading to stronger financial performance and higher stock prices across the stock market.

But the data hides an important trend: the U.S. economy suffered a recession within 12 months of the start of each of the past three easing cycles. These “hard landings” equated to an average 12-month decline in the S&P 500 of 14%. Meanwhile, the U.S. economy avoided recession after the other eight easing cycles. These “soft landings” equated to an average 12-month decline in the S&P 500 of 18%.

That said, the market is expecting the Federal Reserve to start cutting interest rates later this month, and history shows that the S&P 500 could soar in the year following the first rate cut, especially if the economy remains healthy. However, past performance never guarantees future results. Whether the stock market goes up or down is ultimately determined by macroeconomic fundamentals, corporate financial performance, and valuations.

Recession fears resurface amid signs of economic slowdown

Recent economic data has rattled markets (particularly tech stocks) and raised concerns that the Federal Reserve may have waited too long to cut interest rates. U.S. job openings fell for a third straight month in July, and the unemployment rate hit its highest level in nearly three years.

Additionally, manufacturing activity declined for the fifth consecutive month in August. “Demand remains sluggish as current federal monetary policy and election uncertainty make businesses reluctant to invest in capital and inventory,” said Timothy Fiore, chairman of the ISM Manufacturing Economic Survey Committee.

This information indicates a slowdown in the economy and serves as a reminder that a recession, while unlikely, is still possible. The Wall Street Journal The probability of a recession within the next 12 months is predicted to be 28% — the lowest forecast since January 2022, when it was 18%.

S&P 500 companies report strong profits, but valuations are soaring

The S&P 500 is currently experiencing its best earnings season since the fourth quarter of 2021. Companies are reporting earnings growth of about 11% on average in the second quarter of 2024. FactSet ResearchThe average profit margin was 12.2%, an increase of 60 basis points from the previous year and 70 basis points from the average over the past five years.

This last metric points to quality earnings. In other words, earnings aren’t just growing because companies are buying back stock, they’re also growing because they’re generating more profit per dollar of earnings. This isn’t to say that buybacks are bad; it just limits the prospects for companies that rely on share buybacks to grow earnings.

Current stock valuations are less optimistic: The S&P 500 is trading at 25.9 times earnings, higher than its five-year average of 23.5 times earnings and its 10-year average of 21.6 times earnings. This means that many stocks are currently historically expensive, which in itself suggests that the market has already priced in strong second-quarter results.

The bottom line is this: Investors have reason to believe the S&P 500 could rally in the 12 months following the first rate cut, especially if a recession can be avoided. But investors should still tread cautiously in the current market environment, given elevated valuations.