History says Fed interest-rate cut sets up 'crapshoot' for stock-market investors

By William Watts

The 2-week period after a cut has been a binary guide to 'decent gains with low risk or limited gains with high risk': SentimenTrader

What happens to the stock market after the Federal Reserve begins cutting interest rates? The unhelpful answer is that it depends.

"Opinions aside, the imminent cut in the fed-funds rate has been a crapshoot for investors. There was no consistent pattern in forward returns after significant hiking cycles," said Jason Goepfert, senior research analyst at SentimenTrader, in a Tuesday note.

The Federal Reserve is fully expected to cut its key rate when it concludes a two-day policy meeting Wednesday afternoon. What's more, traders see a better-than-60% probability of an extra-large cut of 50 basis points, or half a percentage point, versus a standard move of 25 basis points. Stocks, meanwhile, were little changed Wednesday afternoon, after the S&P 500 SPX briefly traded above its July 16 record close and a day following a record finish for the Dow Jones Industrial Average DJIA.

See: Stocks flirt with record even as Fed considers extra-large interest-rate cut

Investors may recall that the last three initial cuts after a hiking cycle preceded devastating bear markets, Goepfert said. But before that, there was no real pattern, he said, noting there was also no discernible difference in returns based on how far the S&P 500 was from a multiyear high at the time of the first cut.

Investors and analysts have emphasized that context matters when it comes to market performance and rate cuts. An easing cycle can be a positive backdrop for stocks and other assets perceived as risky if rate cuts are seen blunting or heading off an economic downturn.

But when a central bank is viewed as cutting rates because it's behind the curve, having already allowed the economy to slide toward or into the ditch, investors can get rattled.

Goepfert wasn't interested in trying to gauge the path ahead for the economy, writing that the research firm was "not going to participate in the delusion that we can know whether this cut will precede an economic recession, which can dramatically impact forward returns."

Sticking to history, the implications for stocks are mixed, he said. Interestingly, Goepfert observed that maximum risk and reward across time frames showed pretty binary outcomes (see table below)- over the following year, stocks either saw "decent gains with low risk or limited gains with high risk" with no middle ground.

A decent rule of thumb was to watch the next two weeks after a cut, he said, noting that "if risk exceeded reward, then it was a strong suggestion that the following year would be tough."

-William Watts

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09-18-24 0504ET

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