As the Federal Reserve embarks on a long-awaited rate-cutting cycle, some investors worry that overvalued U.S. stocks may already reflect the benefits of easy monetary policy, making it harder for the market to rise further.

On Thursday, a day after the Federal Reserve cut interest rates by 50 basis points to support the economy, investors' joy was obvious, with the three major U.S. stock indexes closing higher, with the S&P 500 and Dow Jones Industrial Average both hitting new all-time highs.

History supports that optimism, especially if the Fed ensures the U.S. economy remains healthy. The S&P 500 has risen an average of 18% a year after the first rate cut in an easing cycle, as long as the economy avoids a recession, according to Evercore ISI data going back to 1970.

But stock valuations have climbed in recent months as investors anticipating rate cuts from the Federal Reserve have piled into stocks and other assets seen as benefiting from easy monetary policy. That has pushed the S&P 500's forward price-to-earnings ratio to more than 21 times, well above its long-term average of 15.7 times. The index has risen 20% this year despite weaker-than-expected U.S. job growth in recent months.

As a result, Robert Pavlik, senior portfolio manager at Dakota Wealth Management, said there is "limited upside driven by rate cuts alone" in the short term. "People are a little nervous about a 20% move in a cooling economy."

Other valuation metrics, such as price-to-book and price-to-sales ratios, also show that U.S. stock valuations are well above historical averages, Societe Generale analysts said in a report. For example, U.S. stocks are currently trading at five times their book value, compared with a long-term average of 2.6 times.

“Current levels can be summed up in one word: expensive,” Societe Generale said.

Lower interest rates will boost stocks in several ways. Lower borrowing costs are expected to spur economic activity, which in turn will boost corporate earnings.

Lower rates also reduce yields on cash and fixed income, making them less competitive with stocks. The benchmark 10-year Treasury yield has fallen about 1 percentage point since April to 3.7%, though it has recovered this week.

Lower interest rates also mean more attractive future corporate cash flows, which typically pushes up valuations. But the S&P 500’s price-to-earnings ratio has rebounded sharply after falling to 15.3 times by the end of 2022 and 17.3 times by the end of 2023, according to LSEG Datastream.

“Valuations were pretty reasonable before this,” said Matthew Miskin, co-chief investment strategist at John Hancock Investment Management. “The multiple expansion we’ve seen over the last year or two is going to be hard to replicate over the next few years.”

With the potential for further valuation gains limited, earnings and economic growth will be the main drivers of the stock market, Miskin and others say. S&P 500 earnings are expected to rise 10.1% in 2024 and another 15% next year, according to LSEG IBES, and the third-quarter earnings season that begins next month will test valuations.

Meanwhile, there are signs that the Fed’s promise of rate cuts may have lured investors in ahead of schedule. Jim Reid, global head of macro and thematic research at Deutsche Bank, who has been examining data going back to 1957, said that while the S&P 500 tends to be flat in the 12 months before a rate-cutting cycle, this time it was up nearly 27%.

“You could say that part of the benefit of this potential ‘recession-free easing cycle’ is borrowed from the future,” Reed said in the report.

To be sure, many investors are not deterred by high valuations and remain optimistic about U.S. stocks.

Valuation is often a clumsy tool when deciding when to buy or sell stocks — especially given that momentum can keep markets rising or falling for months before returning to their historical averages. The S&P 500's forward price-to-earnings ratio has been above 22 times for much of 2020 and 2021, and reached 25 times during the dot-com bubble in 1999.

In addition, rate cuts when stocks are high tend to be good for the market a year later. Ryan Detrick, chief market strategist at Carson Group, said that since 1980, the Federal Reserve has cut interest rates 20 times when the S&P 500 was less than 2% away from its all-time high. Detrick said that each time the index was higher a year later, with an average increase of 13.9%.

“Historically, equities have performed well when the Fed has cut rates and the U.S. economy has not fallen into recession. We expect this time to be no different,” analysts at UBS Global Wealth Management said in a note.

Article forwarded from: Jinshi Data