Analysis — Interest rate cuts are here, but US stocks may have already priced them in

By Lewis Krauskopf

NEW YORK (Reuters) – As the Federal Reserve begins its long-awaited cycle of interest rate cuts, some investors worry that high-valued U.S. stocks may have already priced in the benefits of easier monetary policy, making it harder for markets to rally further.

Investors welcomed the first interest rate cut in more than four years on Thursday, sending the S&P 500 to new records a day after the Federal Reserve cut borrowing costs by a significant 50 basis points to support the economy.

History bears out that optimism, especially if the Fed’s assurances that the U.S. economy is still healthy prove true. The S&P 500 has gained an average of 18% per year after the first rate cut in an easing cycle, assuming the economy avoids recession, according to Evercore ISI data since 1970.

But stock valuations have surged in recent months as investors anticipating the Fed’s rate cuts have piled into stocks and other assets expected to benefit from looser monetary policy. That has left the S&P 500 trading at more than 21 times forward earnings, well above its long-term average of 15.7 times. The index is up 20% this year, even as U.S. job growth has been weaker than expected in recent months.

As a result, near-term “upside from lower rates is a little limited,” said Robert Pavlik, senior portfolio manager at Dakota Wealth Management. “People are just a little nervous about 20% growth in an environment where the economy has cooled.”

Other valuation metrics, including price-to-book and price-to-sales, also show stocks are well above their historical averages, Societe Generale analysts said in a note. For example, U.S. stocks are trading at five times their book value, compared with a long-term average of 2.6.

“The current level can be summed up in one word: expensive,” SocGen said.

Lower interest rates could help stocks in several ways. Lower borrowing costs are expected to boost economic activity, which could boost corporate profits.

The fall in interest rates is also driving down the yields on cash and fixed income, reducing their role as investment competitors to stocks. The yield on the 10-year Treasury note has fallen about a full percentage point since April, to 3.7%, although it rose this week.

Lower rates also mean that companies’ future cash flows are more attractive, which often boosts valuations. But the S&P 500’s P/E ratio has already rebounded significantly after falling to 15.3 in late 2022 and 17.3 in late 2023, according to LSEG Datastream.

“Equity valuations were pretty full before this,” said Matthew Miskin, co-chief investment strategist at John Hancock Investment Management. “It’s going to be hard to replicate the kind of multiple expansion that you’ve had over the last year or two over the next few years.”

With further valuation gains expected to be limited, Miskin and others said earnings and economic growth will be key drivers for the stock market. S&P 500 earnings are expected to rise 10.1% in 2024 and another 15% next year, according to LSEG IBES, with the third-quarter earnings season starting next month expected to test valuations.

At the same time, there are signs that the promise of lower interest rates may already be drawing investors in. While the S&P 500 tended to be flat in the 12 months preceding rate-cutting cycles, it is up nearly 27% this time around, according to Jim Reid, global head of macro and thematic research at Deutsche Bank, who has studied the data going back to 1957.

“One could argue that some of the potential gains from the ‘no-mitigation recession’ cycle were borrowed from the future this time,” Reid said in a note.

There is no doubt that many investors are not discouraged by high valuations and remain positive about the stock.

Valuations are typically an unwieldy tool in determining when to buy and sell stocks — especially since momentum can keep markets up or down for months before they revert to their historical averages. The S&P 500’s forward P/E ratio was higher than 22 times for most of 2020 and 2021, and peaked at 25 during the dot-com bubble in 1999.

Meanwhile, rate cuts near market highs tend to 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 its all-time high, according to Ryan Detrick, chief market strategist at Carson Group. The index was higher a year later each time, with an average gain of 13.9%, Detrick said.

“Historically, stock markets have performed well when the Fed has cut interest rates and the U.S. economy has not been in recession,” UBS Global Wealth Management analysts wrote in a note. “We expect this time to be no exception.”

(Reporting by Lewis Krauskopf in New York; Editing by Ira Iosebashvili and Matthew Lewis)