S&P 500 Period-by-Period Returns following Fed's First Interest Rate Cuts (1974-2024)

Introduction: Fed's 1st Rate Cut and S&P 500 Returns

​As you all know, on September 18, 2024, the Federal Reserve Bank of the U.S. (hereafter referred to as the Fed) lowered interest rates by 0.5% in one go. Now, all investors are wondering whether the U.S. stock market will rise or fall following the Fed's rate cut, and by how much. A key market concern, a potential U.S. recession, is often tied to predicting whether the stock market will experience a major correction or not.

Research generally suggests that Federal Reserve interest rate cuts can positively influence the market during non-recessionary periods. However, if rate cuts are ineffective in preventing a recession or too rapid, suggesting they are too late, they may negatively affect market sentiments.

Let me introduce an excellent quantitative analysis done on this. The research divides the Fed’s rate cuts into fast and slow cycles and shows how the S&P 500 reacted in each case. A fast cycle is defined as having at least four rate cuts in one year, while fewer cuts indicate a slow cycle.

Slow Rate Cut Cycles

Let’s first take a look at the case of the slow rate cut cycle. The dates listed in the "Date" column below are when the Fed made its first rate cut.

Source: Zacks Investment Research / Edited by Neo

There have been four instances of slow rate cut cycles since 1974, and each time there was a strong bull market. After the Fed's first rate cut, the market rose an average of 18.9% over six months, 20.3% over one year, and 38.6% over two years.

The average was slightly lowered due to poor two-year returns in 1980, but excluding 1980, two-year returns ranged between 39% and 66%, showing exceptional performance. It is worth noting that 1980–82 was an unusual period where rates were briefly cut and then raised again, making it hard to classify this as a typical rate cut cycle.

Fast Rate Cut Cycles

Now, let’s take a look at the fast rate cut cycle.

Source: Zacks Investment Research / Edited by Neo

The results here are a bit more complicated. Since 1974, there have been six instances of fast rate cut cycles. Following the first rate cut by the Fed, S&P 500 performance varied: in two cases (2001, 2007) it performed terribly, in one case (1989) it showed moderate growth, and in another case (1981) it dropped over six months before making a V-shaped recovery. The remaining two instances (1974, 2019) resulted in significant gains (though the two-year return in 2019 was boosted by zero-interest-rate policies and massive liquidity injections in response to the COVID-19 crisis after the typical one-year period).

However, due to the very low returns in 2001 and 2007, the average performance across the six cases shows negative returns in all time frames from one month to one year, and after two years, the average return was only 0.78%, essentially flat.

Average of the 10 Rate Cut Cycles Since 1974

So, what happens when we average all 10 rate cut cycles

Source: Zacks Investment Research / Edited by Neo

The returns were quite solid: 10.4% over six months, 10.9% over one year, and 24.9% over two years. Considering that the historical average return of the S&P 500 is about 10%, aggregating 10 cases reveals a tendency toward mean reversion.

However, when using the median, which is less influenced by extreme values compared to the average, the one-year and two-year returns rise to 15.6% and 35.9%, respectively. Ultimately, unless there is an exceptional event like the dot-com bubble burst or the global financial crisis, Fed rate cuts have generally resulted in stock market gains.

There is a more intuitive graph that highlights the exceptional nature of 2001 and 2007. In the below graph, the horizontal axis marks the date of the Fed’s first rate cut, while the vertical axis shows the S&P 500’s return one year later. From this, it’s easy to see that the two cases marked in orange were indeed outliers (of course, 1929 and 1967 weren’t great either, but they did manage small positive returns one year later).

Source: www.schwab.com/learn/story/what-past-fed-rate-cycles-can-tell-us

Is It Time to Go All-In on U.S. Stocks?

So, is it time to confidently go all-in on the U.S. stock market after the first rate cut? Before answering that, let’s revisit the definitions of fast and slow rate cut cycles that were mentioned earlier. A fast cycle is defined as having at least four rate cuts within a year, while a slow cycle refers to fewer cuts. Which category does the rate cut that began in September 2024 fall into? Fortunately, the Fed has provided an answer through its dot plot.

Source: FOMC Summary of Economic Projections; www.bondsavvy.com

The Fed is expected to implement two more rate cuts by the end of 2024, including last week’s 0.5% cut, followed by an additional 1.0% cut by the end of next year (we may assume four cuts of 0.25%), and another 0.5% cut in 2026 (we may assume two cuts of 0.25%). Of course, the Fed's dot plot is updated quarterly and can be adjusted based on prevailing economic conditions, so no one can guarantee that the total 2.5% rate cut will proceed at the predicted pace. However, the first rate cut has already been delivered, and it seems likely that four more cuts will occur within the 12 months from that first cut.

So, this time it almost certainly falls into the "fast rate cut" category. Historically, the "average returns" of the S&P 500 after the first rate cut in a fast rate cut cycle haven’t been great. Of course, it’s important to note that the rapid interest rate cuts weren't the cause of the 2001 or 2007 economic downturns. Instead, they were a reaction to the severe economic conditions and financial crises at the time. Nevertheless, for investors, the specific cause-and-effect relationship is less important.

When the Federal Reserve, with its vast economic data and sophisticated analytical capabilities, abruptly begins rapidly cutting interest rates, investors should at least question the possibility of a looming recession. That’s why, even when Jerome Powell (the current Fed chairman) said, "The U.S. economy remains robust, but we are cutting rates preemptively due to a slight softening in the labor market," investors remain somewhat skeptical.

Investors hope that this fast rate cut cycle turns out to be like the positive cases in 1974 or 1989, but only time will tell which way it will go. That’s why rather than betting everything on one scenario, I recommend keeping at least two scenarios in mind, practicing probabilistic thinking, and building your investment portfolio accordingly. Maybe that’s why Warren Buffett only sold half of his Apple shares.

Thanks for reading. I wish you success in making smart investments!

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