The stock market has rallied hard over the past few months, fueled by optimism over slowing inflation. The Fed, or FOMC, also recently signaled potential interest rate cuts in 2024, which poured gas on an already hot market.
Lower interest rates generally favor stock prices, but there is a catch. Some deep research uncovered a pattern around the federal funds rate that has predicted every significant decline in the S&P 500, going back decades.
Here is why the Fed's actions could mean a bear market is coming, potentially next year.
What rate cuts mean for the S&P 500
Right now, the market is celebrating the increased likelihood of lower interest rates in the future. The FOMC surveys where each committee member believes future rates should be. This survey, called the dot plot, points to reduced rates starting next year and heading lower over the next two to three years.
Stocks typically like lower rates. After all, the growth stock bubble in 2021 was primarily due to rates being suppressed to zero. But rate changes aren't like flipping a switch. Rate changes take time to permeate throughout the broader market and economy.
In other words, transitioning from high to low rates isn't necessarily a smooth process. Consider the chart below.
Target Federal Funds Rate Upper Limit data by YCharts.
Going back to 1990, each time the FOMC began cutting the federal funds rate, the S&P 500 fell. In some cases, these were legitimate bear markets with 20% to 40% drops from the high.
Why does this happen?
The FOMC doesn't cut rates for fun; it cuts because it feels it must stimulate the economy. This translates to the charts. Below, the major bear markets all came after the FOMC began cutting rates. That's because recessions came every time.
- Dot-com bubble in the early 2000s: Rate cuts, then recession.
- Financial crisis in the late 2000s: Rate cuts, then recession.
- Covid-19 pandemic in 2020: Rate cuts, then recession.
Target Federal Funds Rate Upper Limit data by YCharts.
Does that guarantee that a recession will happen this time when the FOMC finally starts cutting the federal funds rate? Of course not. However, inflation was the worst in decades, so the FOMC responded with arguably equally aggressive rate hikes to slow the economy.
Again, the economy takes time to reflect interest rate changes. In other words, the FOMC may have rate-hiked the economy into a recession, but nobody knows it yet. Keep this in mind as employment and economic data come out over the coming months. What happened in the past doesn't guarantee future results, but it's also true that history rhymes, and has rhymed multiple times in the past.
How should investors prepare?
Would a recession be a bummer? Yes, but that doesn't mean people should panic. Recessions are normal. They've happened before and will again in the future. The good news is that recessions don't typically last as long as bull markets. The average recession lasts roughly 17 months.
Also, the S&P 500 is near all-time highs today. That means it's overcome every single recession throughout the market's history. So if we do get a recession, don't panic sell. Use it as an opportunity to buy quality stocks and funds on sale, and wait for the market cycle to run its course.
History shows you'll come out richer on the other side.
