Executive Summary
The Story So Far
Why This Matters
Who Thinks What?
The Federal Reserve cut its benchmark interest rate in September after a nine-month pause, a move historically associated with significant stock market upside. However, Fed Chair Jerome Powell has cautioned that equity valuations are currently elevated, echoing levels seen before past market downturns. The decision to cut rates was driven by concerns over a weakening job market, despite ongoing inflation, which was influenced by tariffs imposed by President Trump.
Federal Reserve’s Rate Cut
The Federal Reserve reduced its benchmark interest rate by a quarter percentage point, marking its first cut since December 2024. This extended pause reflected uncertainty regarding the economic impact of tariffs introduced by President Trump.
While inflation has worsened since the tariffs were announced in April, policymakers prioritized addressing a sharp slowdown in hiring during the summer months. Fed officials ultimately cut rates on September 18.
Historical Market Performance
Historically, the stock market has often performed well under similar conditions. According to Goldman Sachs, since 1985, the S&P 500 has delivered a median return of 13% in the year following a Fed rate cut that occurred after at least a six-month pause.
This median return increased to 16% when the economy successfully avoided a recession. The S&P 500 has already rebounded significantly, adding 14% since January, and is on track for its third consecutive year of double-digit returns, a feat achieved only five times since 1957.
Wall Street Optimism and Powell’s Warning
This historical precedent suggests potential upside for the S&P 500, with many Wall Street analysts forecasting the index could climb higher in the next year. The median forecast places the S&P 500 at 7,494 by October 2026, implying a 12% gain from current levels.
Despite this optimism, Federal Reserve Chairman Jerome Powell recently warned that “Equity prices are fairly highly valued.” While the central bank does not target specific stock prices, Powell’s statement serves as a reminder of elevated valuations.
Elevated Valuations and Historical Precedent
The S&P 500 is currently trading at 22.7 times forward earnings, a premium compared to its 10-year average of 18.6 times. This valuation level has only been observed during two prior periods: the late 1990s dot-com bubble and the 2020 COVID-19 pandemic.
In both historical instances, the S&P 500 eventually experienced a bear market. This historical context suggests the possibility of a similar market outcome today.
Investor Considerations
The current market environment presents a mixed picture, balancing historical indicators of growth following a Fed rate cut with explicit warnings about high valuations from the Federal Reserve. Investors are advised to exercise caution, avoid excessive risk-taking, and consider strategies such as building cash positions to prepare for potential market drawdowns.
