This Stock Market Indicator Has Been 82% Accurate Since 1984. It Signals a Big Rally in the S&P 500. @themotleyfool #stocks $^GSPC

The pandemic triggered the worst bout of inflation in 40 years, and the Federal Reserve reacted with its most aggressive rate-hiking cycle in decades. Between March 2022 and July 2023, policymakers raised the federal funds rate to its highest level since 2001.

The federal funds rate is a benchmark that impacts other interest rates across the economy, like credit card and loan rates. Higher interest rates discourage consumer spending and business investments, which curbs pricing pressure. For instance, the Fed’s rate-hiking campaign has caused inflation to fall more than 6 percentage points since peaking two years ago.

However, higher interest rates also suppress economic growth. Recent reports indicate the labor market is weakening and manufacturing activity is contracting. Based on those signals, investors expect the Federal Reserve to lower interest rates at its September meeting, something policymakers haven’t done since 2020.

In fact, CME Group‘s FedWatch Tool, which uses pricing data from the futures market to predict interest rates, puts the probability of a September rate cut at 100%. That bodes well for stocks. The S&P 500 (^GSPC -0.30%) has historically posted positive returns during the 12-month period following the first rate cut in a cycle.

History says the S&P 500 could soar once the Federal Reserve starts cutting rates

The Federal Reserve has pivoted from rate hikes to rate cuts 11 times in the last four decades. Following the first cut in each cycle, the S&P 500 generated a positive 12-month return nine out of 11 times. In other words, this particular stock market forecasting tool has been 82% accurate since 1984.

The chart below shows how the S&P 500 performed during the 12-month period following the first cut in each loosening cycle, a period during which interest rates are declining.

Data source: Trading Economics.

As shown above, since 1984, the S&P 500 has returned a median of 14% during the 12-month period following the first rate cut in a loosening cycle. That makes sense. Lower borrowing costs should encourage consumer spending and business investments, which should drive strong financial results and share price appreciation across the stock market.

However, there is an important trend buried in the data. The U.S. economy was hit by a recession no more than 12 months after the last three loosening cycles started. Those “hard landings” corresponded with a median 12-month decline of 14% in the S&P 500. Alternatively, the U.S. economy avoided a recession after the other eight loosening cycles. Those “soft landings” corresponded with a median 12-month return of 18% in the S&P 500.

In short, the market expects the Federal Reserve to start cutting interest rates later this month, and history says the S&P 500 could soar during the year following the first cut, especially if the economy stays healthy. However, past performance is never a guarantee of future results. Whether the stock market goes up or down ultimately depends on macroeconomic fundamentals, corporate financial results, and valuations.

Recession fears have resurfaced amid signs of a cooling economy

Recent economic data has rattled the market (especially technology stocks) and raised concerns about whether the Federal Reserve has waited too long to lower interest rates. U.S. job openings declined for the third consecutive month in July, and unemployment reached its highest level in nearly three years.

Additionally, manufacturing activity declined for the fifth consecutive month in August. “Demand remains subdued, as companies show an unwillingness to invest capital and inventory due to current federal monetary policy and election uncertainty,” said Timothy Fiore, chair of the ISM Manufacturing Business Survey Committee.

That information points to a cooling economy and serves as a reminder that a recession is still a possibility, albeit a remote one. In July 2024, economists surveyed by The Wall Street Journal put the odds of a recession within the next 12 months at 28%, the lowest estimate since 18% in January 2022.

S&P 500 companies are reporting strong profits, but valuations are elevated

The S&P 500 is currently having its best earnings season since the fourth quarter of 2021. Companies have reported profit growth of nearly 11% on average in the second quarter of 2024, according to FactSet Research. And the average profit margin of 12.2% represents a 60-basis-point expansion from the prior year and a 70-basis-point expansion from the five-year average.

That last metric points to high-quality earnings. In other words, earnings are not just increasing because companies are repurchasing stock but also because they are making more money on each dollar of revenue. That does not mean stock buybacks are bad. However, companies that rely on share repurchases to grow earnings have limited prospects.

Current valuations are less encouraging. The S&P 500 trades at 25.9 times earnings, a premium to the five-year average of 23.5 times earnings and the 10-year average of 21.6 times earnings. That means many stocks are historically expensive right now, which itself suggests that the market has already priced in strong second-quarter financial results.

Here’s the bottom line: Investors have reason to believe the S&P 500 could move higher during the 12-month period following the first rate cut, especially if the economy avoids a recession. But given that valuations are elevated, investors should still be cautious in the current market environment.