In September, the Federal Reserve started a new rate-cutting cycle, something the stock market has seen only five other times in the last three decades. Specifically, after raising the federal funds rate to a two-decade high to fight severe post-pandemic inflation, policymakers finally pivoted to interest rate cuts on Sept. 19.
The federal funds rate is a benchmark that impacts other rates across the economy, such as those for personal loans, credit cards, and mortgages. Policymakers reduce the benchmark rate to stimulate economic growth, which could logically translate into robust stock market returns.
Indeed, the broad-based S&P 500 (^GSPC -1.32%) and growth-focused Nasdaq Composite (^IXIC -2.24%) have historically performed well during the first 12 months of cutting cycles. That hints at a big move in 2025.
History says the stock market could soar in 2025
The S&P 500 and Nasdaq Composite are two of the most popular U.S. stock market indexes. The former is commonly regarded as the best gauge for the overall U.S. stock market because it includes about 80% of domestic equities by market value. The latter is generally seen as a barometer for growth stocks because it is heavily weighted toward the technology sector.
The Federal Reserve has pivoted from interest rate hikes to interest rate cuts five times in the last 30 years. The chart below examines how the S&P 500 performed during the 12-month period following the first rate reduction in each cutting cycle.
|
First Rate Cut |
S&P 500 Return (12 Months) |
|---|---|
|
July 1995 |
19% |
|
September 1998 |
21% |
|
January 2001 |
(14%) |
|
September 2007 |
(21%) |
|
July 2019 |
10% |
|
Median |
10% |
Source: The Federal Reserve, YCharts.
As shown above, over the last three decades, the S&P 500 returned a median of 10% during the 12-month period following the first rate cut in a cycle. We can apply that figure to the current situation to make an educated guess about the coming months.
Specifically, the current cycle began when the Federal Reserve lowered its benchmark rate by a half point on Sept. 19. Since then, the S&P 500 has advanced 2%, leaving implied upside of roughly 8% through September 2025. That roughly aligns with the long-term average, but history says the Nasdaq could deliver more robust returns.
The chart below examines how the Nasdaq Composite performed during the 12-month period following the first rate reduction in each cutting cycle over the last three decades.
|
First Rate Cut |
Nasdaq Composite Return (12 Months) |
|---|---|
|
July 1995 |
22% |
|
September 1998 |
58% |
|
January 2001 |
(26%) |
|
September 2007 |
(20%) |
|
July 2019 |
31% |
|
Median |
22% |
Source: The Federal Reserve, YCharts.
As shown above, during the last three decades, the Nasdaq Composite returned a median of 22% during the 12-month period following the first rate cut in a cycle. Here again, we can apply that figure to the current situation to make an educated guess about the coming months.
Specifically, since the current cutting cycle began on Sept. 19, the Nasdaq Composite has advanced 3%. That leaves implied upside of roughly 19% through September 2025, which is several percentage points above the long-term average of 11%.
One plausible reason for that pattern is the growth-focused nature of the Nasdaq. Growth-stock valuations depend heavily on future earnings, and earnings grow faster when rates are low because companies pay less to borrow money to invest in their businesses.
To be clear, the future profit trajectory of any company improves in a low-rate environment, but growth stocks benefit the most because (by definition) they have the capacity to grow revenue and earnings faster, leading to a larger expansion in valuation multiples.
Investors should remember that each situation is unique, and past performance is never a guarantee of future results. The stock market’s performance in the coming months depends on macroeconomic fundamentals and valuations.
The economy appears healthy, but stocks are historically expensive
In general, the U.S. economy is in good shape. Inflation is below 3% and should trend lower, the unemployment rate is stable around 4.1%, and gross domestic product increased at an annualized 2.8% in the third quarter on robust growth in consumer spending, coupled with a modest increase in nonresidential business investments.
Indeed, J.P. Morgan strategist Sarah Stillpass recently commented, “In June, we thought the economy looked to be at its healthiest in decades. Since then, we have seen just that.” A healthy economy should drive strong financial results for the companies in the S&P 500 and the Nasdaq Composite, which could lead to strong returns in both stock indexes.
However, investors should know that valuations are elevated even when accounting for strong future earnings growth. The S&P 500 currently trades at 22 times forward earnings, a premium to its 10-year average of 18.1 times forward. Historically high prices could lead to worse-than-expected returns in the coming months.
Here’s the bottom line: The stock market has seen the Federal Reserve pivot to interest rate cuts only five times during the last 30 years. That change in monetary policy has usually led to solid returns, especially in the growth-focused Nasdaq Composite. But investors should be aware that stocks would likely fall sharply at the first sign of bad news for the economy, simply because valuations are already stretched.
