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News last week that inflation fell more than expected in October reinforced the view that the Fed has finished its most aggressive campaign to raise interest rates in four decades.
This could be a boon for the stock market and 401(k).
Over the last 10 interest rate hike cycles dating back to 1974, the S&P 500 rose an average of 14.3% in the 12 months following the Fed’s final rate hike, according to an analysis by Ryan Detrick, chief market strategist at Carson Collection.
In comparison, the average index return through 2022 is 7.5% over five years, 10.4% over 10 years, 7.5% over 30 years, and 10% over the past century, according to Reuters. NerdWallet.
Investors really like it when the central bank stops hitting them with interest rate hikes.
What happens when the Fed raises interest rates?
Detrick points out that increases in interest rates lead to higher costs for mortgages, auto loans, credit card purchases and other loans, dampening economic activity and impacting corporate profits. It also makes stocks a relatively less attractive investment than bonds, which carries less risk for the now-increasing return.
Of course, the pain is ostensibly for a good reason – fighting inflation that could become entrenched, and which, at least according to the Fed, could cause further damage.
Stopping raising interest rates does the opposite, brightening the economic outlook and making stocks more attractive than bonds. It also removes a large cloud of uncertainty from the market, says Adam Turnquist, chief technical strategist at LPL Financial.
Will the stock market recover?
From the day the Fed started raising interest rates in March 2022 until last Monday, the S&P 500 saw some wild swings but eventually came to a standstill at 4411. However, since the Department of Labor released the positive CPI report in Early Tuesday, the benchmark stock index was up more than 100 points, or 2.3%.
“If July is the last high, which we think it was, then stocks perform historically well a year after this last high,” Detrick says.
LPL Financial’s Turnquist called it a “stock market catalyst.”
There are some caveats.
First, Fed officials said they did not rule out additional interest rate increases, even after the encouraging inflation report, although most economists did.
How does an interest rate pause affect the market?
Although the end of rate hikes fueled double-digit market gains in eight of the 10 rate hike cycles over the past half-century, the S&P 500 suffered sharp 12-month losses in two of those cycles. A halt to rate increases in July 1981 could not avert a 16.4% market decline amid a brutal recession triggered by rates that were still in nosebleed territory at a level below 17%.
Likewise, drawing the curtain on interest rate increases in June 2000 could not have averted the dot-com recession of 2001.
“The dot-com bubble has burst, limiting the impact of the pause and subsequent interest rate cuts,” Turnquist says.
At the other end of the spectrum, in 1995, the Fed’s decision to end large interest rate increases and then cut interest rates likely helped achieve a 35% market return in the year following the last hike. But so did a strong economy, boosted by software-based productivity gains.
In other words, during most of the Fed’s previous stay-put decisions, the agency was the “primary driver” of strong market gains, Turnquist says. But sometimes other forces were at play.
Such dynamics could affect stocks and your 401(k) in the coming months.
What happens in an earnings recession?
In the third quarter, for example, S&P 500 companies appeared to have emerged from a year-long earnings slump (marked by declining quarterly earnings), according to recent earnings reports. It can juice the market.
The same also applies to the recent continuation of strong productivity gains, fueled by artificial intelligence, which should allow employers to raise wages without raising prices, Detrick says.
Are stocks currently overvalued?
At the same time, shares are relatively expensive at 18.6 times estimated earnings over the next 12 months, above the 10-year average of 17.6, according to Turnquist and FactSet. This puts a greater burden on the economy and profits to do well, Turnquist says. If the United States experiences a moderate or severe recession, it could hurt the market regardless of what the Fed does or does not do.
Another thing to consider: Strong market gains following the Fed’s decisions to halt interest rate increases may also have been supported by subsequent interest rate cuts. In December 2018, the Fed raised interest rates for the last time, contributing to market gains of 11.7% and 17.7% over the next three and six months, respectively.
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But in August 2019, Fed officials began cutting interest rates, which helped boost S&P yields to 27.9% for the 12 months after the last rise.
In the medium term, a Fed that stays on the sidelines could continue to boost stocks. But investors are eyeing a rate cut by May or perhaps earlier, according to futures markets.
If the Fed pushes back against that narrative and continues to embrace the “go higher for longer” mantra, “stocks could pull back and give up some of that recovery,” Turnquist says.
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