Stock-market investors clamor for rate cuts. They should be careful what they wish for.

Stock-market investors clamor for rate cuts. They should be careful what they wish for.

Stock-market investors seem to be clamoring for rate cuts from the Federal Reserve, although the S&P 500 has been on a record-breaking run even without them. History shows investors should be careful what they wish for, according to research from Wells Fargo Investment Institute.

Investors want a rate cut, because the longer rates remain elevated, the greater the risk that something will eventually break and cause a significant economic or market disruption, Austin Pickle, investment strategist analyst at WFII, said in a Monday note.

“Historically, though, the arrival of a Fed rate cut cycle has tended to coincide with a sizable stock-market drawdown,” he wrote. “Since 1974, the average drawdown has been roughly 20% over 250 days following the first Fed rate cut.” (See chart below.)

Investors came into 2024 enthusiastic over prospects for what were seen as six or even seven quarter-point rate cuts before year-end. Hotter-than-expected inflation and resilient economic growth in the first quarter saw those hopes fade, and investors are now penciling in around two cuts, perhaps starting in September.

Yet stocks have rallied, albeit with megacap tech shares doing most of the heavy lifting. The S&P 500 is up more than 14% in the year to date and has rallied around 20% since the Fed delivered its last rate hike on July 26.

It goes to show that — as is the case with most market phenomena — context matters.

Pickle noted that outside of the 2000-01 cycle, which was characterized by the bursting of the dot-com bubble, stocks posted double-digit returns during four of the past five pauses following the final hike in a rate cycle.

This makes sense, he noted, because a Fed on hold essentially signals that conditions are consistent with growth that is neither too hot nor too cold and inflation that is decelerating, creating an environment in which stocks have typically performed well.

Similarly, when a rate cut does come, the rationale for that policy easing will likely be crucial to the market reaction.

“If the Fed tweaks policy to adjust real rates for falling inflation, we believe stocks will likely perform well over the tactical time frame (6 to 18 months),” Pickle said. “On the other hand, if the Fed is forced to cut aggressively in response to a macro or market disruption, we would expect stock performance to suffer.”