The year 2024 has seen a positive trend in the stock market, but recent concerns about a potential economic slowdown leading to a recession have left investors feeling uneasy. To counter this possibility, the Federal Reserve is ready to lower interest rates, aiming to provide a boost to consumers and businesses that have been struggling despite overall economic growth.
Will the reduction in interest rates be sufficient to stabilize the economy and turn things around, or does the Fed’s initial interest rate cut signal a market downturn? This question is on the minds of many investors, but recent studies suggest that there is reason for optimism.
Stocks Perform Well After Interest Rate Cuts
Investors may have valid concerns about the state of the economy as the Fed prepares to lower interest rates following one of the fastest rate hike campaigns in history between 2023 and 2023. Typically, the Fed begins cutting rates in response to a weakened economy, with lower rates often indicating an impending recession.
However, lower interest rates can have positive implications for companies and stock valuations. Businesses that are sensitive to interest rates, such as small banks, real estate investment trusts (REITs), and heavy borrowers, stand to benefit significantly from lower rates. Additionally, lower rates can boost stock prices as investors factor in future earnings at reduced rates, increasing the present value of those earnings today.
While these are encouraging developments, investors must navigate the time between the rate cut and its impact. Monetary policy typically has a delayed effect, often taking around six months to be fully felt. During this period, a declining economy may continue to weaken, necessitating further rate cuts and intervention from the Fed. As the economy falters, corporate profits could decline significantly, leading to a decrease in investor sentiment and stock prices.
Research conducted by Hartford Funds indicates that investors should remain positive. Historical data shows that U.S. stocks tend to perform well, with an average 11% increase (adjusted for inflation) one year after the Fed initiates rate cuts. This suggests a strong reason for investors to maintain their stock holdings.
Hartford’s analysis of 22 instances between 1929 and 2019 when the Fed first reduced rates revealed that stocks, bonds, and cash performed differently over the following 12 months. Stocks saw an average 11% increase after inflation, with varying returns based on whether the rate cut coincided with a recession.
Greg McBride, CFA, Chief Financial Analyst at Bankrate, highlights the favorable impact of lower interest rates on stocks, making safe investments like cash and fixed income less attractive while facilitating corporate borrowing and growth, ultimately driving stock prices higher.
Notably, stocks saw significant returns following rate cuts in June 1995 and September 1998, with gains of 23% and 25% respectively in the subsequent year. Similar to the current scenario, the mid-1990s experienced mild slowdowns amidst a strong economy.
Government bonds recorded a 5% increase, corporate bonds a 6% increase, and cash a modest 2% increase one year after rate cuts, according to Hartford’s findings. While some periods showed stocks underperforming, only six out of the 22 periods reviewed by Hartford resulted in negative after-inflation losses.
McBride emphasizes the long-term outperformance of stocks compared to bonds and cash, particularly during periods of interest rate cuts.
Investor Response to Falling Interest Rates
Changes in investor sentiment can lead to market fluctuations, with some investors selling in anticipation of a recession while others buy during market dips. However, Hartford’s data suggests that investors who maintained their stock holdings ultimately fared better.
Remaining steadfast amid market volatility can be challenging, especially amidst negative economic news. It requires a resilient approach to withstand the uncertainty and refrain from impulsive actions.
For investors navigating falling interest rates and the possibility of an economic downturn, the following strategies can be beneficial:
1. Think and Invest Long Term
McBride recommends a substantial allocation to stocks for long-term investment horizons like retirement, as stocks historically deliver strong compounded returns. Investing in an S&P 500 index fund can provide consistent long-term gains, but requires enduring through market fluctuations.
Attempting to time the market is discouraged, as missing out on periods of high returns can impact long-term growth. Staying invested during market downturns is crucial for maximizing returns over time.
2. Continue to Add to Investments on Dips
Investors can consider increasing their investments during market downturns to capitalize on discounted prices. Buying on the dip can lead to accelerated gains as stock prices recover. Opting for a stock index fund like the S&P 500 provides diversification and reduces risk compared to individual stocks.
Implementing an automated investment strategy, such as dollar-cost averaging, can help mitigate risk by spreading out purchases over time and avoiding market timing.
3. Step Back from the Noise
During market volatility, it is common for investors and the media to react anxiously, potentially influencing investment decisions. Stepping back from the noise, reviewing financial plans, and ensuring emergency funds are well-funded can help investors weather market turbulence.
Refocusing on long-term wealth-building goals and seeking guidance from a financial advisor can provide reassurance amidst market uncertainties.
Conclusion
Evidence from stock research suggests that passive investing often yields better results for investors. Maintaining a long-term perspective and aligning investment strategies accordingly can lead to favorable outcomes, even during economic slowdowns. It is essential for investors to conduct thorough research and seek professional advice before making investment decisions.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. Past performance of investment products does not guarantee future price appreciation.