Buoyed by the Federal Reserve's aggressive first rate cut since the early days of the pandemic and rising expectations that the central bank may keep the economy from tumbling into a long-feared recession, stock indexes closed at new record highs this week, sparking hopes of the start of next major rally in equities.
Both the S&P 500 and the Dow Jones Industrial Average closed at all-time highs on Sept. 19, with the indexes up 10.2% and 8.6%, respectively, from their troughs in early August following a weaker-than-expected jobs report.
Stocks have surged since the Fed on Sept. 18 approved a 50-basis-point reduction in its benchmark interest rate, beginning an expected cycle of rates set to run through 2025 following the central bank's multiyear effort to fight inflation by boosting rates to their highest levels in more than two decades.
"Rate-cut expectations played a major role in the stock market rebound off the early August pullback, but only because the increasingly dovish Fed policy expectations for sooner-and-deeper rate cuts were accompanied by encouraging economic data that helped ease the suddenly urgent fears of an imminent recession in the wake of the July jobs report," said Tyler Richey, a co-editor with Sevens Report Research.
'Fed put'
Equities investor confidence has been lifted by the Fed shifting its focus from driving down inflation to preventing further deterioration of the labor market, even though unemployment is barely over 4%, said Matthew Weller, global head of research with FOREX.com and City Index.
"With the median Fed member projecting a mere 0.1% rise in the unemployment rate to 4.4% by the end of 2024, traders are confident that the 'Fed Put' has returned if the labor market slows any further, giving them more confidence to put capital to work," Weller said.
The Fed put is a market principle that the central bank will likely step in to act before a potential economic crash.
"The Fed is clearly looking to minimize the left tail risk of a deteriorating labor market, essentially putting a cap on the unemployment rate," said Sonu Varghese, director of investment platform at Carson Wealth. "That is likely to be positive for the economy and markets over the next year."
A Fed that is seen as supportive of the economy will be positive for cyclical stocks, those most impacted by economic cycle changes, and could most lift mid- and small-cap stocks as smaller companies tend to be most negatively impacted by higher interest rates, Varghese said.
Nearly all sectors of the S&P 500 lost ground from the last time the large-cap index closed at an all-time high on July 16 and its most recent low on Aug. 5.
Information technology stocks fared the worst over that stretch, falling by 14.6%, followed by consumer discretionary, which dropped 12.8%. These two sectors have led the way since the August trough, rising 12.4% and 15.5%, respectively.
Sector performance between the July highs and August lows was particularly defensive as investors rotated away from cyclical and higher valuation stocks in the tech and consumer discretionary sectors and tended to move toward traditional defensive stocks, like utilities and consumer staples.
The sectors hit the hardest during that roughly one-month market slump are now in the middle of relief rallies, with the most interest-rate sensitive sectors, such as financials and real estate, surging on rate cut expectations. The S&P 500 financials is up 11.5%, and real estate is up 9.6% from the August low.
The new highs this week may have ended months of "sideways" trading in equities, but it remains unclear whether the rally will be sustained by more rate cuts, said Bret Kenwell, a US investment analyst with eToro.
"When it comes to rate cuts, it's been a 'when' not 'if' situation," Kenwell said. "While lower rates are certainly a positive for equities, improving earnings and expanding market breadth have been the driving forces for the bull market. That said, rate cuts are acting like a cherry on top right now."
Rate cut expectations will weigh heavily on the stock market through the end of 2024, primarily as they relate to the outlook for economic growth, said Richey with Sevens Report Research.
"Soft landings are historically elusive, and the Fed has notably never pulled one off after a deep and prolonged yield curve inversion like we have seen in the Treasury market since the summer of 2022," he said. "Using history as a guide, we are in a late cycle environment and very likely closer to seeing a lasting market top established than a new leg higher in a sustainable bull market."