History shows that when the Fed moves from raising interest rates to lowering interest rates without plunging the economy into a recession, the S & P 500 can rise dramatically, as happened in the 1990s。

Now, "the market seems to be borrowing from that history," said Jurrien Timmer, Fidelity's director of global macro strategy.。

After the first meeting of the Federal Reserve in 2024, people are increasingly convinced that the US economy will achieve a soft landing。The S & P 500, which hit a series of all-time highs in January, also seems to confirm that the current artificial intelligence-focused stock market rally is similar to the stock market rally brought about by the Internet boom of the 1990s.。

In a deflationary environment, the rapid adoption of a transformative technology can lead to explosive stock market gains。However, there is still a big difference between now and the 1990s, which means that the S & P 500 may not be on the same trajectory as before。While the U.S. stock "Big Seven" may have more staying power than the star stocks of the Internet age, poor fiscal conditions and the Fed's fears of another bubble could limit the "Big Seven" rally。

It has now been more than six months since the Fed last raised interest rates on July 26 last year.。Markets expect the Fed to announce its first rate cut on May 1。It's a good time to review the performance of the S & P 500 and Nasdaq after previous Fed rate hikes and consider what that might mean for today's stock market outlook。

Timmer said: "If the Fed starts cutting rates because the economy is in recession, then corporate earnings tend to fall and the stock market could fall.。"

1995Fed cuts rates in

Review the process of the Fed's shift to raising interest rates in the mid-1990s.。The last time the Fed raised interest rates was on February 1, 1995.。That time the Fed also adopted a rapid tightening policy, doubling its key interest rate to 6% in 12 months。Then, as inflation fell back to 2%, the Fed began abandoning its last three planned rate hikes on July 6 of that year.。

This turn provides a "runway" for the stock market to take off.。The S & P 500 rose 34% in 1995, its best annual gain since the 1950s.。

Looking back at this period of history, you will find that the situation at the time was strikingly similar to the current cycle.。With core inflation falling below 2% annualised in six months, the Fed's announcement of a rate hike may be nearing its end。At the time, policymakers said they were abandoning three quarterly increases this year, despite market bets on deeper rate cuts.。

In the six months following the Fed's last rate hike in February 1995, and in the six months following a shortened rate hike cycle that began and ended in March 1997, the S & P 500 gained a cumulative 19 percent, while the Nasdaq gained more than 30 percent each time.。

This is much better than usual。Over the past nine cycles, the S & P 500 and Nasdaq have averaged 11% and 12% gains, respectively, in the six months since the Fed's last rate hike.。

Stocks gain little since Fed suspends rate hikes

So what has happened so far after the Fed suspended rate hikes？Actually, not so good。In the six months following the July 26, 2023, rate hikes were suspended, the S & P 500 gained 7% and the Nasdaq gained 9%.。

These modest gains, however, do not suggest a rollercoaster performance for stocks and a dramatic change in sentiment around the time the Fed last raised rates.。

With the March 2023 banking crisis raising fears of a credit crunch, the Fed is starting to play down rate hike expectations。The Fed's statement helped the stock market get hot, driven by artificial intelligence.。On May 24 last year, Nvidia's stunning outlook for chip sales provided a huge boost to the market, and the Nasdaq's full-year gain on the eve of the Fed's last rate hike reached 35%。

But then, stock market growth hit a snag。A surge in federal borrowing following a deal to raise the debt ceiling last June led to a sharp rise in Treasury yields。This led to a 10% correction in the S & P 500 and Nasdaq around the end of October.。

Financial conditions then became almost suddenly tame due to a series of tame inflation reports。Then the economy grew faster than expected, the stock market soared again, and Wall Street began to see Fed policy as a boost, not a problem.。

However, the recent all-time highs set by the S & P 500 come more than two years later。Jim Reid, a strategist at Deutsche Bank, noted that this is the seventh longest period of consecutive record highs since the 1920s.。He said the long-term consolidation was due to extremely high valuations in 2021, which were based on "the hope of always being close to zero interest rates."。

Stock market valuation after Fed rate cut

So far, the forward P / E ratio of the S & P 500 has exceeded 20 times in only two periods since World War II (the epidemic boom of 2021 and the dotcom bubble)。However, neither period has met initial expectations.。

Current valuation levels are high enough to make this Fed rate cut stand out from almost all other policies。

Based on analysts' consensus earnings expectations over the next 12 months, the S & P 500 is trading at a price-to-earnings ratio of 20, according to FactSet..25 times。By this standard, before the Fed cut interest rates in 1995, the S & P 500 had an expected price-to-earnings ratio of less than 15 times.。

On the other hand, valuations prior to the 1998 Fed rate cut were also close to 20 times expected P / E, and this rate cut led to huge gains that are likely to gradually rise to 25 times。

When does the Fed cut interest rates?？

While the U.S. jobs data remains strong, the market expects a 38 percent chance of the Fed cutting rates for the first time at its March 20 meeting and a 94 percent chance of a rate cut by May 1.。

If history is any guide, stock returns should be above average。In the 11 cycles of rate hikes and rate cuts since 1982, the S & P 500 and Nasdaq have returned an average of nearly 10% in the six months following the first rate cut。

There are two exceptions, both of which occurred during the worst times in the stock market.。The Fed began cutting interest rates in January 2001 during the bursting of the dotcom bubble and in September 2007 when the housing crash began to intensify during the subprime mortgage crisis.。

The stock market's best performance so far came in the Internet age, following the Fed's first rate cut in September 1998.。The S & P 500 is up 25% in the following six months and the Nasdaq is up 44%。

The current period is similar to the late 1990s, but the impact goes far beyond technology-driven investment returns。

Long-cycle expansion supports S & P 500 valuation

In the late 1990s, the economy grew rapidly and inflation remained moderate despite unemployment at its lowest level in three years.。Wall Street is beginning to suspect that this expansion, already the longest in the post-World War II period, is likely to continue, driven by increasing business IT investment and timely inventory management.。

Now, at a time when most on Wall Street thought a soft landing was impossible, the Fed's ability to hold on to a soft landing has once again boosted confidence in a long-run expansion.。

Jason Draho, head of asset allocation for the Americas at UBS Global Wealth Management, said that without the contagion shock, "the economy is likely to enter its 15th year of expansion."。

Delahoe wrote that despite the extreme supply-demand imbalance, the economy was able to "return to balance and control inflation fairly quickly without causing too much economic pain," confirming the view that the United States "naturally does not fall into recession easily."。

One reason is the evolution of the economy towards knowledge-based services, with manufacturing's share of output halving since 1970 and less sensitive to interest rates and energy prices.。

"Think of it as a 'superization" of the entire economy, where prices dynamically adjust to attract supply and curb excessive demand in most industries, something that would have been impossible 40 years ago. "。"

Barring an overwhelming shock, the expected long-cycle expansion should support high valuations of stocks, as was the case in the late 1990s。

In a recent report, strategist Ed Yardeni explained that stock market valuations tend to move inversely with inflation and interest rates, rising as the latter fall.。He added: "The decline in earnings during the recession has also depressed the valuation multiples of these earnings.。"

And for money market flows after the Fed's rate cut, Yadney said in the report that there is no need to worry that a cyclical recession will bring greater risk aversion to investors。He believes that as the Fed cuts interest rates, a lot of money is likely to flow into bond and equity markets, driving a surge in both markets, especially equity markets.。

Both Delahoe and Yadney wrote that the U.S. economy may be heading for "20 years of prosperity."。This would combine strong growth with moderate inflation, as investment in revolutionary technologies would lead to massive productivity gains, just as they did in the late 1990s.。

Recent GDP figures have a late 90s feel。In the second half of 2023, the economy was 4.1% growth, while inflation fell to 2%。

AIBoom Will Drive '20 Years of Prosperity "？

Delahoe said one of the main reasons inflation slowed last year was a surge in the labor supply, which eased wage pressures.。However, he believes that "labor supply growth is unlikely to be sustained, but if productivity growth investment and artificial intelligence take over, then the 'prosperous 20 years' is more likely to be achieved."。"

OpenAI launches generative AI chatbot ChatGPT in November 2022, kicking off AI investment boom。Following OpenAI, a number of large technology companies such as Microsoft, Google's parent company Alphabet and Meta quickly launched artificial intelligence tools。This is similar to the Netscape Navigator browser released in 1994, which then triggered the dotcom boom。

AI Stock Starts Vertical Rise Since ChatGPT Launches。In May last year, Nvidia surprisingly predicted that third-quarter revenue would reach $11 billion, far exceeding Wall Street's estimate of $7.2 billion.。As a result, the AI chip leader posted $13.5 billion in revenue in that quarter, followed by $18 billion in the next quarter.。

Since ChatGPT's debut, Nvidia has quadrupled its performance, just like Cisco did that year.。Cisco reached incredible heights in the dotcom bubble that year。

However, Nvidia shares are valued at 31 of the expected price-to-earnings ratio..4 times, must quadruple to approach Cisco's peak in early 2000。The broader S & P 500 information technology sector is valued at 28 times the expected price-to-earnings ratio.。By the beginning of 2000, that number was close to 50.。

The overall valuation of the S & P 500 is 20.25 times forward P / E, a level rarely reached and never maintained for more than a few years。But as the Fed moves to cut interest rates, valuation concerns may not prevent stocks from rising further。

Technology dominance drives valuation

Wilmington Trust Chief Investment Officer Tony Roth and colleagues wrote in the 2024 outlook that in some ways, the valuation of the S & P 500 may not be as excessive as it seems.。

Faster-growing technology companies "tend to earn valuation premiums due to potential future earnings growth and higher profit margins," and these companies have a larger weighting in the S & P 500 than in past decades.。

FactSet noted on January 29 that six of the "Big Seven" stocks (excluding Tesla) are expected to grow earnings by an average of 54% in the fourth quarter of last year, while earnings per share of the other 494 stocks in the S & P 500 are expected to decline by an average of 10%..5%。

The IT sector currently accounts for 21% of the expected earnings of the S & P 500..5%, up from 17% at its peak in March 2000。This heavier tech component alone adds half a percentage point to the S & P 500's expected price-to-earnings ratio.。This underestimates the impact, as only Apple, Microsoft and Nvidia are among the Big Seven in the IT industry.。Tesla and Amazon are in the S & P 500 consumer discretionary segment, while Google and Meta are in the communications services segment。

The Wilmington Trust also highlighted Apple and other big tech companies shifting to recurring services revenue and reducing their reliance on upfront hardware sales.。"In general, investors are willing to pay extra for a more stable, predictable and sticky stream of earnings, which tend to come from subscription-based models," the analysts wrote.。"

AIThe Winner's Risk

In addition, Wilmington believes that artificial intelligence is changing the rules of company valuation.。

In its outlook, the company said: "The need for scale and first-mover advantage in the AI race (where large US technology stocks are currently leading) could justify higher valuations and could also signal significant future profitability.。"

This means that winning the AI "championship" earlier may not bring huge risks。By contrast, in January 1999, then-Fed Chairman Alan Greenspan said he could only explain stock valuations based on a "lottery premium."。People bet on the chance of a "big payoff," but most of the "lottery" is lost.。Even a rare "lottery" like Amazon's will take more than a decade to finally pay off。

The Fed will shift from its last rate cut in November 1998 to a sustained rate hike starting in June 1999 as the Internet stock boom drives consumption and business equipment spending to soar。This played a role in the bursting of the dotcom bubble。

The question now is, will we repeat the 1990s?？Yadney wrote in the report that he expects the S & P 500 to rise to 5,400 by the end of 2024, nearly 10 percent above current levels.。He said his "main concern" was another tech-fueled crash.。

Yardeni said that "the Fed's next big mistake could be to blow up a speculative stock market bubble," the bursting of which could lead to a recession.。Fed Chairman Jerome Powell must know this, he argues。"If so, then he should reiterate that he is in no hurry to cut interest rates."。"

However, Powell sounded rather dovish in his press conference after the latest Fed meeting。Powell said that "as long as inflation continues to decline, we don't see strong economic growth as a problem," and he did not mention the problem of overvalued stocks.。

Treasury yields may give the stock market "Trouble”

Stock market investors tend to focus on the 10-year U.S. Treasury yield.。This is the risk-free rate at which Wall Street measures current valuations based on future cash flows。

In the six months following the Fed's first rate cut in 1998, the 10-year Treasury yield rose 69 basis points to 5.28%。But that hasn't stopped the stock market's epic rally。

Yet the United States is enjoying a post-Cold War peace dividend and its first federal budget surplus in decades.。In 1998, public debt was 42% of GDP, and declining。Now it's 98% of GDP and growing。As debt service costs rise, a heavy debt burden could amplify the damage from rising Treasury yields。

When the yield on the 10-year U.S. Treasury note soared to 5% in October last year, the U.S. conducted a "drill" to deal with potential future fiscal crises.。An equally dramatic pullback has pushed the current rally to an all-time high.。

However, Wilmington Trust believes that if the stock market does not surge as much as it did in 1999, the culprit may be rising Treasury yields。If higher yields become the new normal, that eliminates one of the key factors driving investors' willingness to pay increasingly high P / E ratios for stocks。