The Federal Reserve has a dual mandate: It must maintain price stability and maximum employment throughout the economy. To fulfill that mandate, the Fed has multiple policymaking tools at its disposal.
The Federal Reserve Board of Governors controls the discount rate and reserve requirements, and the Federal Open Market Committee (FOMC) engages in open market operations, which primarily involve adjusting the federal funds rate.
The federal funds rate influences other rates across the economy, such as the rate on business loans and credit cards. That means the FOMC can lower the federal funds rate to stimulate economic growth and raise the federal funds rate to slow economic growth. For instance, the FOMC has raised its benchmark rate by 5 percentage points since March 2022 -- the fastest series of rate hikes since the early 1980s -- in an effort to bring inflation down.
Those rate hikes have indeed helped stabilize prices. Inflation has now declined for nine consecutive months. But the aggressive nature of those rate hikes has also brought the economy to the brink of recession. In fact, some members of the FOMC expect a mild recession before the end of the year, and that forecast has coincided with a decline in investor sentiment.
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On the bright side, chairman Jerome Powell recently signaled that the FOMC was nearing the end of its rate-hike cycle. In fact, policymakers may have already reached that point. History says that bodes well for the stock market.
History also says the S&P 500 is headed toward a new bull market
The federal funds rate has peaked 11 times since 1970, meaning there have been 11 rate-hike cycles during that period. The S&P 500 index produced an average return of 14.8% during the year immediately following those cycles, with gains in eight of the 11 one-year periods, according to data from Charles Schwab. In other words, if the FOMC is done raising the federal funds rate for the time being, history says the S&P 500 will climb nearly 15% in the next 12 months.
That figure is significant for two reasons. First, the S&P 500 is currently 14% off its high, so a 15% gain would carry the index to a new all-time high. Second, the S&P 500 is currently in a bear market, but a 15% gain would carry the index into bull market territory.
Investors should never attempt to time the market
Readers may be wondering why the stock market would rise following a rate-hike cycle. Higher interest rates suppress economic growth by disincentivizing borrowing, so it stands to reason that the stock market should fall with each successive rate hike.
The answer to that question delves into human psychology. Uncertainty makes people uncomfortable.
The market is often described as "forward looking" because investors make decisions based on their expectations about the future, but uncertainty complicates the decision-making process. So when the Fed eliminates some of that uncertainty by signaling a pause in the rate-hike cycle, investors tend to respond bullishly. In other words, once a rate-hike cycle reaches its end, investors are already anticipating the first rate cut, which will stimulate economic growth.
That same logic explains why the stock market tends to fall well before a recession begins, and why it tends to rebound well before a recession ends. In fact, the S&P 500 started climbing toward new highs before economic activity bottomed during every recession in the last five decades, with only one exception. The lesson here is that market-timing strategies are doomed to fail.
What this information means for investors
As discussed, history says the S&P 500 will rise about 15% over the next year if the FOMC has indeed reached the end of its rate-hike cycle. Additionally, even if the U.S. economy slips into a recession this year, staying out of the market until the recession is over doesn't make sense. History also says the S&P 500 will be on the upswing by the time that hypothetical recession ends.
Investors can capitalize on that information by purchasing an S&P 500 index fund right now. Of course, past events never guarantee future results, so investors shouldn't bank on a 15% gain over the next year.
But it still makes sense to buy an S&P 500 index fund right now. In fact, it makes sense to buy an S&P 500 index fund on a consistent basis, regardless of what the market may do in the near future. The index has weathered a number of recessions and bear markets over time, but its long-term total return is still close to 10% annually.
Put another way, investors who regularly buy an S&P 500 index fund can confidently expect their money to grow by about 10% each year over the long run.
Alternatively, investors willing to do their homework can consider buying individual stocks. The economic uncertainty of the past year has left many good stocks trading at discounted prices. Investors can also consider blending both strategies. Personally, I keep some of my money in an S&P 500 index fund and some in individual stocks.
