The stock market has had a stellar year, buoyed by a recovery from the 2022 bear market, the buzz around new generative artificial intelligence (AI) technologies, and the anticipation of falling interest rates. As we look to 2024, investors are hopeful that this momentum will persist.
Predicting the stock market is a fool’s game. The economy could strengthen or weaken. Geopolitical tensions could escalate. The promise of generative AI could either be fulfilled or fall short. However, one certainty we have for 2024 is the expectation of three quarter-point interest-rate cuts from the Federal Reserve. This forecast, given by the central bank in its last meeting in December, has been closely watched by investors. The S&P 500 (^GSPC) jumped 1.4% on Dec. 13, the day the Fed announced its rate-cutting forecast, and had previously jumped nearly 2% on Nov. 14, when a cooler-than-expected inflation report increased the chances of imminent rate cuts.
While forecasts are not set in stone, it’s worth understanding the typical market response to Fed rate cuts. The principles of finance dictate that when interest rates rise, stock valuations tend to fall as bonds become more attractive. Conversely, when interest rates fall, stock valuations rise as money shifts from bonds to stocks.
However, other factors come into play, including the health of the economy. Since 2000, there have been three major rate-cutting cycles. The Fed cut rates in 2000 during the dot-com bubble burst, in 2007 and 2008 amidst the great financial crisis, and in 2019 and early 2020 as the coronavirus pandemic hit. The stock market’s performance during these periods was mixed.
The expected rate-cut cycle for 2024 differs from the previous ones this century. The earlier three coincided with a recession, but a recession is not expected this time around. The economy has shown resilience over the past year, and the unemployment rate remains low. Typically, rate cuts are a response to economic weakness. However, this upcoming cycle seems to be a correction for the Fed’s aggressive rate increases to counter inflation, which is now close to the central bank’s goal of 2%.
This rate cycle bears some resemblance to the “Volcker Recession” of the early 1980s. Then-Fed Chair Paul Volcker raised rates aggressively to tame inflation. When the rate steadily decreased in 1982, the stock market soared, with the S&P 500 gaining more than 60% in less than a year.
However, there’s no perfect historical comparison for the current stock market. Like the Volcker Recession, the previous rate increases were a response to inflation rather than an attempt to stimulate the economy. But this is a different moment from 1982. Stocks are already at all-time highs after a bullish 2023, suggesting that investors have already factored in next year’s rate cuts.
This could mean that the Fed will have to be even more dovish than expected to push stocks higher, possibly requiring more than three rate cuts to exceed expectations.
Falling rates should generally benefit the stock market and certain businesses, but investors should be mindful that expectations of rate cuts may already be priced in. Other factors, such as corporate earnings growth, strong economic data, and continued breakthroughs with generative AI, could keep the recent rally going.
As we prepare for a new bull market, we can expect stocks to continue to rise in 2024. The stock market is likely to benefit from the Fed’s more accommodative monetary policy, even if the anticipation of it has already driven stocks higher.
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