When the Federal Reserve pivots from rate hikes to rate cuts without tipping the economy into recession, history shows that the S&P 500 advance can be dramatic — never more so than in the back half of the 1990s.
Now, “the market seems to be borrowing a page from that history book,” Jurrien Timmer, Fidelity’s director of global macro strategy, told IBD.
After the Fed met in 2024 for the first time, conviction is growing that it will nail a U.S. economic soft landing. And the S&P 500’s charge to a series of record highs in January seems to be validating the comparison between the current AI-focused stock market rally — fueled by Nvidia (NVDA), Microsoft (MSFT) and other titans — and the 1990s’ dot-com boom.
Rapid adoption of a transformative technology in a disinflationary climate can produce explosive stock market gains. Yet important differences exist between the 1990s and today that could alter the S&P 500’s trajectory. While the Magnificent Seven may have more staying power than the dot-com era’s shooting stars, the dismal fiscal picture and Fed fears of another bubble could limit their ascent.
Just over six months have passed since the last Fed rate hike of this cycle on July 26. Markets expect the first Fed rate cut on May 1. That makes it a good time to review how the S&P 500 and Nasdaq performed after prior Fed rate pivots and consider what that might mean for today’s stock market outlook.
“If the Fed is pivoting because a recession is brewing, then earnings tend to decline and the stock market can suffer a drawdown,” Timmer said in an email. “But a recession doesn’t always follow, and 1994-1995 certainly comes to mind as a cycle where the glass was very much half full (if not overflowing!).”
Fed Rate Cuts In 1995
The Fed hiked rates for the last time on Feb. 1, 1995, ending a rapid tightening that saw its key interest rate double to 6% in 12 months. Then, with inflation easing to 2%, “Alan Greenspan ‘gave back’ the last three rate hikes,” starting on July 6 of that year, Timmer recounted.
That pivot provided a runway for the stock market’s takeoff. The S&P 500’s 34% advance in 1995 is still its best annual gain going back to the 1950s.
The parallels with the current cycle are striking. With core inflation falling below 2% at a six-month annualized rate, the Fed has declared a likely end to rate hikes. Policymakers have signaled their intention to “give back” three quarter-point increases this year, though markets are betting on even deeper cuts.
In the six months after the Fed’s final hike in February 1995, and again after an abbreviated hiking cycle that started and ended in March 1997, the S&P 500 racked up 19% gains, while the Nasdaq surged more than 30% in each instance.
That’s much better than the norm. Over the past nine cycles, the S&P 500 and Nasdaq averaged 11% and 12% gains in the six months after the final Fed rate hike.
S&P 500, Nasdaq Gains Muted Since Fed Rate Hike
So how does this Fed pivot stack up so far? Not great, actually. In the six months following July 26, the S&P 500 rose 7% and the Nasdaq 9%.
Yet those moderate gains don’t begin to hint at the stock market roller-coaster ride and sea change in sentiment that unfolded leading up to and following that last Fed rate hike.
As the regional bank crisis stirred fears of a credit crunch in March 2023, the Fed began to reel in rate-hike expectations. Its loosening grip let in the oxygen that helped artificial intelligence stocks catch fire. A stunning sales outlook from Nvidia on May 24 provided a giant spark, fueling a 35% year-to-date Nasdaq rally on the eve of the Fed’s final hike.
But the stock market hit a wall. Treasury yields exploded higher amid a surge in federal borrowing after the June deal to raise the debt ceiling. That triggered 10% corrections for the S&P 500 and Nasdaq through late October.
Then financial conditions turned balmy almost as suddenly, thanks to a string of mild inflation reports. Even as the economy grew faster than expected and the stock market surged anew, Wall Street began to see Fed policy not as a problem, but as a tailwind.
Still, the S&P 500’s record high on Jan. 19 and beyond was more than two years in coming. That was the seventh-longest stretch between new highs going back to the 1920s, noted Deutsche Bank strategist Jim Reid. The prolonged consolidation, he says, was due to sky-high valuations in 2021 that were justified based on “the hopes of near-zero rates in perpetuity.”
Stock Market Valuations After Fed Rate Cuts
Until now, the Covid-era boom through 2021 and the dot-com bubble were the only periods since at least World War II when the S&P 500’s forward price-earnings ratio eclipsed 20. Neither period lived up to that hype, at least initially.
While valuations have moderated, they’re high enough to make this Fed pivot stand out from almost all others.
According to FactSet, the S&P 500 is trading at 20.25 times forward earnings, based on analyst consensus earnings over the coming 12 months.
By that metric, the comparison between the current cycle and the Fed’s 1995 pivot doesn’t look as compelling. The S&P 500 was valued at under 15 times forward earnings heading into the 1995 Fed rate cut.
On the other hand, valuations heading into the 1998 Fed rate cut that led to massive gains also were near 20 times forward earnings. They proceeded to rise to 25.
When Will Federal Reserve Cut Interest Rates?
If history is a guide, above-average stock returns should follow. Over the past 11 cycles dating back to 1982, the S&P 500 and Nasdaq have averaged nearly 10% returns over the six months following an initial rate cut.
The two exceptions came in some of the worst times for the stock market. That was when the Fed cut rates starting in January 2001 in the midst of the dot-com crash and in September 2007 as the subprime housing crash was beginning to spiral.
By far the best performance came in the dot-com era, following the Fed’s initial easing in September 1998. The S&P 500 powered to a 25% gain and the Nasdaq 44% over the ensuing six months.
The current period resembles the late 1990s in ways that go well beyond technology-fueled investment gains.
China Woes Curb Inflation
Back in 1998, the Fed cut rates to stem fallout from currency crises that had spread from Asia to Russia, blowing up the Long-Term Capital Management hedge fund. LTCM’s demise created systemic issues that forced the Fed to ease, a bit like the Fed backing down from additional rate hikes as the regional bank crisis hit this spring.
In 1998, the global currency crises spiked the dollar and sandbagged inflation, opening the door to multiple Fed rate cuts despite solid economic growth on the homefront.
Now it’s the Chinese economy causing global ripples. The world’s strongest growth engine before Covid, China is struggling to shake a hangover from the massive overbuilding of property and infrastructure.
“China’s property bubble has burst, and the deflationary consequences are far greater and more global than those following the bursting of similar bubbles in Japan during the late 1980s and in the US during the Great Financial Crisis of 2008,” wrote strategist Ed Yardeni.
Beijing’s ongoing stimulus efforts could still bear fruit. But for now, weak demand from China is helping to keep a lid on oil prices, even as Middle East tensions blaze, Yardeni says. Meanwhile, December prices for imported Chinese goods fell 3% vs. a year earlier.
Long Expansions Bolster S&P 500 Valuations
The promise of lengthy expansions may be another similarity. In the late 1990s, economic growth raced ahead, yet inflation remained tame despite a three-decade low in unemployment. Wall Street began to suspect that the expansion, already the longest in the post-World War II era, might run on and on, facilitated by ever-rising business IT investment and just-in-time inventory management.
Now the Fed’s ability to stick a soft landing when most of Wall Street thought it couldn’t be done is again feeding belief in an almost never-say-die expansion.
Had the pandemic shock not occurred, “The economy could well be in year 15 of an expansion,” wrote Jason Draho, head of asset allocation at UBS Global Wealth Management in the Americas, in a Jan. 15 blog post.
‘Uberfication’ Of U.S. Economy
The economy’s ability “to get back into balance and inflation under control fairly quickly without much economic pain,” despite extreme supply and demand dislocations, validates the view that the U.S. “is not naturally prone to recession,” Draho wrote.
One reason is the economy’s evolution to knowledge-based services, with manufacturing’s share of output falling by half since 1970 and less sensitivity to interest rates and energy prices. But that’s only part of the story, he says.
“Think of it as the ‘Uberfication’ of the entire economy, where prices adjust dynamically to induce supply and curb excess demand across most sectors, a reality that wasn’t remotely possible 40 years ago.”
Expectation of long expansions, outside overwhelming shocks, should support high stock valuations, as was the case in the late 1990s.
Stock market valuations tend to be inversely correlated with inflation and interest rates, rising as the latter fall, Yardeni explained in a recent note.
“It’s the drop in earnings during recessions that also depresses the valuation multiple of those earnings,” he added.
Money Market Flows After Fed Rate Cuts
Not having to worry about periodic recessions would give investors a big reason to be less risk-averse. Perhaps the clearest evidence of ongoing risk-aversion is the $6 trillion in assets in low-yielding money market mutual funds. That includes $2.3 trillion held by retail investors.
As the Fed cuts rates, Yardeni wrote, “lots of that money might move into the bond and stock markets, fueling melt-ups in both markets, especially the stock market.”
Draho and Yardeni both have written that the U.S. economy may be headed for a “Roaring 20s.” That would combine strong growth with tame inflation as investment in revolutionary technologies yields high productivity gains, much like the late 1990s.
Recent GDP data had that late ’90s feel. The economy grew at a 4.1% pace in the back half of 2023 as inflation slowed to a 2% annual rate.
AI Boom To Drive Roaring 20s?
Still, Draho says, a major reason for easing inflation last year was the surge in labor supply, which cooled wage pressures. “That labor supply growth is unlikely to continue, but if productivity-enhancing investment and AI pick up the baton, then a ‘Roaring ’20s’ regime becomes more likely,” he wrote.
OpenAI’s November 2022 public launch of the generative AI chatbot ChatGPT flipped the switch on the artificial intelligence investment boom. That’s akin to the Netscape Navigator browser’s 1994 release, which democratized the internet and unleashed the dot-com craze. OpenAI partner Microsoft quickly pushed toward offering AI tools, along with Google parent Alphabet (GOOGL) and Meta Platforms (META), among others.
AI stocks began to go vertical last May, as Nvidia stunned observers with its outlook for $11 billion in revenue for the July quarter. Wall Street had expected $7.2 billion. As it turned out, the AI chip leader rung up $13.5 billion in the quarter, then $18 billion the next.
Having quadrupled since ChatGPT’s debut, Nvidia is drawing comparisons to Cisco Systems (CSCO). The networking giant scaled hard-to-believe heights in the dot-com bubble as a tech infrastructure play that was bound to win no matter which websites came out on top.
Yet Nvidia stock’s valuation, at 31.4 times forward earnings, would have to quadruple to approach Cisco’s early 2000 peak.
The broader S&P 500 Information Technology sector is valued at 28 times forward earnings. But it nearly hit 50 in early 2000.
The overall S&P 500 valuation of 20.25 times forward earnings is a level it has rarely attained and never held for more than a few years. But valuation concerns probably won’t prevent further stock market gains as the Fed pivots to rate cuts.
Tech Dominance Drives Valuations
In some ways, the S&P 500’s valuation may not be as stretched as it appears, Wilmington Trust Chief Investment Officer Tony Roth and colleagues wrote in their 2024 outlook.
Faster-growing technology companies, which “tend to command a valuation premium because of the potential future earnings growth and fatter profit margins,” have a bigger presence in the S&P 500 than in past decades.
FactSet noted on Jan. 29 that six of the Magnificent Seven stocks, excluding only Tesla (TSLA), were expected to report an average of 54% earnings growth for Q4, while EPS was seen slipping 10.5% for the other 494 S&P 500 stocks on average.
The IT sector now accounts for 21.5% of projected S&P 500 forward earnings, up from 17% at the March 2000 peak. That heavier tech composition alone adds a half-point to the S&P 500 forward earnings multiple. And that understates the effect, because the IT sector only includes Apple (AAPL), Microsoft and Nvidia among the Magnificent Seven. Tesla and Amazon.com (AMZN) are part of the S&P 500 Consumer Discretionary sector, while Google and Meta Platforms are part of the Communications Services sector.
Wilmington Trust also highlighted the shift by Apple and other big techs toward recurring services revenue and relying less on upfront hardware sales.
“Generally, investors are willing to pay extra for the steadier, more predictable, and ‘stickier’ stream of earnings that tends to come from subscription-based models,” the analysts wrote.
AI Winners Already Here?
On top of that, Wilmington believes that AI is changing the rules when it comes to valuing companies.
“The necessity of scale and the first-mover advantage in the AI race — which U.S. megacap tech stocks currently lead — may justify a higher multiple and also potentially denote tremendous future earnings power,” the firm said in its outlook.
The implication is that crowning AI winners so early may not entail massive risk. By contrast, then-Fed chair Alan Greenspan said in January 1999 that he could only explain stock valuations based on a “lottery premium.” People were betting on the chance of a “very big payoff,” even though most tickets would be losers. Even the rare ticket like Amazon that eventually paid off would take more than a decade to do so.
As internet stock fever fueled surging consumption and business equipment spending, the Fed would pivot from a final rate cut in November 1998 to sustained rate hikes starting in June 1999. That played a role in the dot-com crash.
Could we be in for a replay?
Fed Rate Cuts: How Much And When
Yardeni wrote on Jan. 23 that he sees the S&P 500 rising to 5,400 by the end of 2024, still nearly 10% above current levels. He says his “main concern” is another tech-led melt-up.
“The Fed’s next big mistake could be inflating a speculative stock market bubble,” whose bursting could cause a recession.
Fed chair Jerome Powell “must know that,” Yardeni said. “If so, then he should reiterate that he is in no rush to lower interest rates.”
Yet Powell sounded pretty dovish at his news conference after Wednesday’s Fed meeting. “We don’t look at stronger growth as a problem,” Powell said, as long as inflation continues to come down, and he made no mention of high stock valuations.
Treasury Yields Could Rain On S&P 500 Party
Stock market investors tend to focus on the 10-year Treasury yield. That’s the risk-free rate Wall Street uses to gauge current valuations based on future cash flows.
In the six months after the initial Fed rate cut in 1998, the 10-year Treasury yield rose 69 basis points to 5.28%. But that did nothing to stem the epic stock market rally.
The U.S., however, was enjoying the post-Cold War peace dividend and the first federal budget surplus in decades. In 1998, publicly held debt was 42% of GDP — and falling. Now it’s 98% of GDP and inexorably rising. That heavy debt load could magnify the damage from higher Treasury yields as debt-service costs escalate.
The U.S. had a fire drill for the potential fiscal crisis ahead when the 10-year yield spiked to 5% in October. The equally dramatic retreat ignited the current rally to all-time highs.
Still, if stocks don’t party like it’s 1999, Wilmington Trust figures higher Treasury yields would be a likely culprit. If higher yields become “the new normal, that removes one of the key tail winds that contributed to investors’ readiness to pay ever-higher multiples for stocks.”
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