Analysis: Richly Valued US Stock Market May Find Limited Benefit from Rate Cuts, According to Reuters

By Lewis Krauskopf

NEW YORK (Reuters) – As the Federal Reserve initiates a long-anticipated cycle of rate cuts, some investors express caution over whether U.S. stocks, which are currently highly valued, have already factored in the advantages of looser monetary policy, potentially limiting future market gains.

On Thursday, investors responded positively to the Fed’s first rate cuts in over four years, propelling the stock market to new highs following a significant reduction of 50 basis points aimed at strengthening the economy. Historical trends bolster this optimism; since 1970, the S&P 500 has typically seen an average annual gain of 18% after the initial rate cut in an easing cycle, provided the economy does not slip into recession, according to data from Evercore ISI.

However, recent months have witnessed a surge in stock valuations, as investors anticipating Fed cuts have flocked to equities and other assets poised to benefit from the easing. The S&P 500 is currently trading at over 21 times its forward earnings, significantly above its long-term average of 15.7. The index has gained around 20% this year, despite weaker-than-expected employment growth figures in the U.S. recently. This leads some analysts to conclude that the immediate upside from lower rates may be limited. Robert Pavlik, a senior portfolio manager at Dakota Wealth Management, noted, "People just get a little bit nervous around being up 20% in an environment where the economy has cooled."

Other valuation metrics, including price-to-book and price-to-sales ratios, also indicate that stocks are trading well above historic averages, according to analysts at Societe Generale. For instance, U.S. equities are currently valued at five times their book value, compared to a long-term average of 2.6. "The current levels can be summarized in one word: expensive," they stated.

Lower interest rates are expected to bolster equity markets in various ways. Decreased borrowing costs may stimulate economic activity, potentially boosting corporate earnings. Additionally, a reduction in rates lowers returns on cash and fixed-income investments, making equities a more attractive option. The yield on the benchmark 10-year Treasury bond has dropped by about one full percentage point since April, sitting at 3.7%, although it has seen a slight uptick this week. Lower rates also enhance the attractiveness of future corporate cash flows, often pushing valuations higher.

However, the price-to-earnings (P/E) ratio for the S&P 500 has rebounded significantly, rising from a low of 15.3 in late 2022 to 17.3 in late 2023. Matthew Miskin, co-chief investment strategist at John Hancock Investment Management, remarked, "Equity valuations were pretty reasonably full going into this. 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 in the technology sector have also surpassed long-term averages, driven by substantial gains in stocks like Nvidia, which has seen a 140% increase this year. This segment trades at around 28 times earnings, compared to a long-term average of 21. Given the limitations on further valuation increases, Miskin and others indicate that earnings and economic growth will be pivotal in influencing stock market performance moving forward. S&P 500 earnings are projected to rise by 10.1% in 2024 and another 15% in 2025, according to forecasts, with the upcoming third-quarter earnings season likely to challenge current valuations.

Additionally, it appears that the prospect of lower rates may have already attracted investors. Historically, the S&P 500 has remained relatively flat in the year leading up to rate-cutting cycles, but this time, it has surged nearly 27%. Jim Reid, Deutsche Bank’s global head of macro and thematic research, noted this as a potential sign that some gains associated with a "no recession easing cycle" may have been realized prematurely.

Despite the elevated valuations, many investors remain optimistic about stock performance. Valuations are often a cumbersome metric for timing investments, as market momentum can drive stocks up or down for extended periods before reverting to historical averages. The S&P 500’s forward P/E ratio remained above 22 for a substantial duration in 2020 and 2021, peaking at 25 during the dot-com bubble in 1999.

Furthermore, historical precedents indicate that rate cuts occurring near market peaks tend to yield positive outcomes for stocks in the year following. The Fed has implemented rate cuts 20 times since 1980 when the S&P 500 was within 2% of an all-time high. Remarkably, the index was higher a year later in each instance, averaging a gain of 13.9%. Analysts from UBS Global Wealth Management assert, "Historically, equity markets have performed well when the Fed was cutting rates while the U.S. economy was not in recession. We expect this time to be no exception."