Jumping the Gun on the Fed: Has the U.S. Stock Rally Already Overpriced?

The short-term boost to U.S. stocks from the Fed’s rate cuts may be limited, as future market drivers shift...

As the Federal Reserve embarks on its long-anticipated rate-cutting cycle, some investors worry that overvalued U.S. stocks may have already priced in the benefits of easier monetary policy, making further gains harder to achieve.

On Thursday, one day after the Fed slashed rates by 50 basis points to support the economy, investors' enthusiasm was clear, with all three major U.S. stock indices rising. The S&P 500 and Dow both hit new all-time highs.

Historical trends support this optimism, particularly when the Fed ensures the U.S. economy remains healthy. According to data from Evercore ISI, dating back to 1970, as long as a recession is avoided, the S&P 500 has gained an average of 18% in the year following the Fed’s first rate cut of an easing cycle.

However, in recent months, as investors anticipated rate cuts, they poured into stocks and other assets expected to benefit from loose monetary policy, pushing up valuations. This has led the S&P 500’s forward price-to-earnings (P/E) ratio to exceed 21, well above its long-term average of 15.7. Despite slower-than-expected U.S. job growth in recent months, the index is up 20% this year.

As a result, Robert Pavlik, senior portfolio manager at Dakota Wealth Management, noted that the upside potential driven purely by rate cuts is limited in the short term. “With the economy cooling, people are a bit nervous about a 20% gain,” he said.

A report from Société Générale analysts highlighted that other valuation metrics, such as price-to-book and price-to-sales ratios, also indicate that U.S. stocks are trading well above historical averages. For example, U.S. stocks are currently trading at five times their book value, compared to a long-term average of 2.6.

Société Générale noted: "One word summarizes the current level: expensive."

Lower interest rates will boost the stock market in several ways. Lower borrowing costs are expected to stimulate economic activity, which in turn will improve corporate profits.

Falling interest rates also reduce the yields on cash and fixed-income investments, making them less competitive with stocks. The benchmark 10-year U.S. Treasury yield has fallen by about 1 percentage point since April, down to 3.7%, although it rebounded slightly this week.

Lower rates also make future corporate cash flows more attractive, typically boosting valuations. However, according to LSEG Datastream, the S&P 500’s P/E ratio has already rebounded sharply from 15.3 at the end of 2022 to 17.3 at the end of 2023.

Matthew Miskin, co-chief investment strategist at John Hancock Investment Management, commented, "Valuations were quite reasonable until recently. The multiple expansion we’ve seen over the past couple of years will be hard to replicate in the next few years."

With limited room for valuations to rise further, earnings and economic growth will become the key drivers for the stock market, Miskin and others say. According to LSEG IBES, earnings for S&P 500 companies are expected to grow by 10.1% in 2024 and another 15% the following year. The upcoming third-quarter earnings season, starting next month, will be a test for current valuations.

Meanwhile, there are signs that the Fed’s rate-cut promise may have already lured in investors ahead of time. Jim Reid, global head of macro and thematic research at Deutsche Bank, who has studied data since 1957, noted that while the S&P 500 typically stays flat in the 12 months leading up to a rate-cutting cycle, it has surged nearly 27% this time around.

Reid wrote in a report, “You could say that part of the gains from this potential ‘non-recession easing cycle’ has been borrowed from the future.”

That said, many investors are not deterred by high valuations and remain optimistic about U.S. stocks.