The S&P 500 (^GSPC 0.34%) has advanced 13% year to date, closing at record highs more than two dozen times in the process. Most analysts deemed such a performance unthinkable when President Donald Trump began imposing sweeping tariffs just a few months ago.
However, the economy has been relatively resilient, with artificial-intelligence spending adding more than a percentage point to gross domestic product growth in the first half of 2025. And corporate earnings were better than expected in the first and second quarters, especially across the technology sector.
History says the stock market could maintain its upward trajectory. Interest rates just did something that has historically coincided with sizable gains in the S&P 500. Here's what investors should know.
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The market tends to perform well when the Fed starts cutting rates after a lengthy pause
The Federal Reserve recently reduced its benchmark interest rate by a quarter of a percentage point, the first rate cut since December 2024. Policymakers had been in the middle of a cutting cycle when President Trump began his second term, but paused when he announced sweeping tariffs that many economists warned would have catastrophic consequences.
The Fed took a wait-and-see approach, balancing the possibility that tariffs would cause inflation to spike (which may have warranted higher interest rates) against the possibility that tariffs would weaken the jobs market. The second scenario won out. The U.S. economy added an average of 27,000 workers per month between May and August, the worst four-month stint since 2010 (excluding the pandemic).
So policymakers started cutting rates again on Sept. 17 after a nine-month pause. Interestingly, the stock market has usually performed well under those conditions.
Since 1985, when the Fed has cut rates after holding steady for at least six months -- something that only happened eight times during that period -- the S&P 500 has returned a median of 13% during the next year, according to Goldman Sachs. The median return was 16% when the economy avoided a recession.
That data implies substantial upside in the next year. Specifically, the S&P 500 closed at 6,600 on Sept. 17, so the index should advance 13% to reach 7,458 during the next year if its performance matches the historical average. That implies about 12% upside from its current level of 6,632.
Wall Street is optimistic, but investors should be cautious
FactSet Research aggregates the median 12-month target price on every stock in the S&P 500, then adjusts those numbers based on the market-cap weight for each company to create a "bottom-up" forecast for the overall index. That forecast currently says the S&P 500 will hit 7,310 in the next year, which implies 10% upside from its current level of 6,632.
Nevertheless, investors have reason to be cautious. S&P 500 companies are expected to report much slower earnings growth in the second half of 2025 as tariffs cut more deeply into profit margins. And inflation as measured by the Consumer Price Index has reaccelerated due to tariffs, rising to 3.1% in August after dropping to 2.8% in May. That trend could continue in the months ahead as lower interest rates ripple across the economy.
Meanwhile, the S&P 500 trades at 22.5 time forward earnings, an expensive multiple seen during just two periods since 1985: the dot-com bubble and the pandemic. The market eventually crashed both times. There is no guarantee that history will repeat itself, but the S&P could decline sharply if the economic outlook deteriorates or companies report worse-than-expected earnings in the coming quarters.
What should investors do against that backdrop? Avoid stocks trading at absurdly rich valuations, especially those of companies that are unprofitable. Limit purchases to your highest-conviction ideas, and prioritize reasonably priced stocks whose earnings are virtually certain to be much higher five years from now.
Lastly, now is a good time to accumulate some extra cash in your portfolio. Doing so will ensure you are ready to capitalize on the next drawdown.
