What Past Fed Rate Cycles Can Tell Us

How will the stock market behave when the Federal Reserve starts lowering rates? It's a question we get often—but unfortunately one that doesn't have a simple answer.

The Fed has embarked on 14 rate cycles since 1929, and, in retrospect, some patterns emerge.

First, it's important to note that past performance should be taken with a grain of salt, and 14 interest rate cycles hardly constitute a statistically significant sample size. Still, the data is compelling: 86% of the time, the S&P 500^® Index posted positive returns 12 months after the initial rate cut. The two negative periods—which occurred after the Fed began cutting rates in 2001 and in 2007—may feel uncomfortably recent, but neither economic environment resembles today's; the former happened amid the dot-com implosion, and the latter was precipitated by the subprime mortgage crisis.

Looking at what's driving Fed policy this time around, rather than its past motivations, may give us a better sense of where the market may be heading.

It's often said that the Fed takes the stairs up and the elevator down in an interest rate cycle, meaning it raises rates gradually—step-by-step—and cuts them quickly when a threat to the economy emerges. So far, the current cycle has done the opposite.

The rate hikes from March 2022 to July 2023 came fast and furious. Policymakers reacted sharply to a sudden spike in inflation with aggressive tightening: elevator up.

In contrast, the unwinding of those higher rates is expected to be gradual as the Fed continues its fight against inflation: stairs down.

Research shows that "defensive" sectors—essential industries that tend to be more resistant to economic uncertainty, such as health care and utilities—generally perform well when interest rates are rising. Conversely, "cyclicals"—sectors that benefit from an accelerating economy, such as consumer discretionary and industrials—have greater potential when rates drop. So, investors may wonder if a sector shift to cyclicals is on the horizon.

This is another market dynamic that depends on how fast the Fed is cutting rates. Based on analysis from Ned Davis Research, cyclicals have often done best when the Fed enters into a period of gradual rate decreases—as is expected in this cycle.

One twist here is that the definitions of defensive and cyclical sectors have themselves shifted over time. For example, technology historically has been in the cyclicals group, but in this Fed tightening cycle, large technology companies have taken on many of the characteristics of more-defensive companies and have outperformed the market. Their huge cash holdings (among other factors) have insulated them from higher borrowing costs and helped generate income as rising rates made cash more rewarding.

As much as the Fed's rate policy matters, investors should also keep an eye on:

• The economy: A resilient economy is a plus for the stock market—and the Fed's willingness to prioritize fighting inflation may signal its continued confidence in the economy's underlying fundamentals.
• Investor sentiment: Investors' confidence is running reasonably high—but that in and of itself can be a warning sign. After all, those on the bullish side of the boat may rush to the other side if their rosy outlook bumps up against signs of a faltering economy.

• Valuations and earnings: Some valuation metrics have touched new highs this year, but valuation alone should never be taken as a signal to buy or sell. What's more, we're in a period of earnings acceleration—in which many companies' quarterly earnings growth is outpacing that of the prior quarter or two¹—which might soon substantiate and even spur on those already higher highs.

Taken together, there's still a fair amount of uncertainty ahead with the anticipated rate cut and the upcoming presidential election. In times like these, it's best to rebalance your portfolio regularly to stay on top of rate moves and market responses—and have confidence that your long-term plan can ride out any near-term gyrations.