Money Talk: Rate cut gives tailwind to stocks for Q4

Despite starting the third quarter with a significant downturn, US stocks, as measured by the Standard and Poor’s 500 Index returned to their upward trend and posted strong returns through September. Compounding this good news is the fact that the rally broadened out beyond the “Magnificent 7” stocks (Apple, NVIDIA, Microsoft, Alphabet, Amazon, Meta, and Tesla) that have been driving the S&P 500 Index higher over the past year. The Russell 2000 Index of small company stocks posted a 9.3% return for the quarter, besting the large cap stock index’s 5.9% return by a wide margin. International stocks also recorded solid gains. The MSCI EAFE Index returned 7.3% for the three months ending in September.

Investors also returned to dividend-paying stocks as the rally broadened out. The iShares Core S&P 500 Growth ETF posted a return of only 3.7% for the quarter while its counterpart, the iShares Core S&P 500 Value ETF saw a return of 9.0%. This is a significant reversal of the relative performance of these two segments of the S&P 500 Index we have seen over the past several quarters.

Relative valuations give some insight into why the rotation into value stocks may be underway. Based on relative price to earnings ratios, value stocks are currently cheap relative to growth stocks. That is, they may have more upside potential than growth stocks.

International stocks may also be gaining favor with investors based on their relative price to earnings ratios and dividend yields. The current P/E ratio of the MSCI All Country Word ex-U. S. Index stands at 13.8 times, just above its 20-year average of 13.1 times. In contrast. The S&P 500 Index’s current P/E is 21.5, well above its long-term average of 15.8. This relative undervaluation of foreign stocks also makes their dividend yields more attractive (3.1% for the MSCI All Country World ex-U. S. Index versus the S&P 500’s 1.4% yield).

The Federal Reserve’s stance on interest rates will continue to be in focus for investors, with doubt remaining as to whether inflation can in fact be tamed without ushering in a recession. During Q3, there were signs that the labor market might be weakening as job growth slowed and the unemployment rate ticked slightly higher. Still, the Fed decided not to reduce rates at its July meeting, triggering a stock market selloff. At its September meeting, the Fed finally ended its most aggressive rate hiking cycle in 40 years, taking the federal funds rate down fifty basis points to 4.75 – 5.00%.

Typically, the Fed takes a more measured stance toward rate movements, shifting them up or down in twenty-five basis point increments. The larger rate cut raised some concerns that the Fed was more worried about the economy. However, the employment picture and other economic indicators suggest that the economy is still expanding. Fed Chair Powell’s comments following the rate decision indicated that the Fed opted for a larger cut as a pre-emptive move to support the labor market while it is still strong, rather than when weakness is growing.

If the Fed can maintain an environment with moderating inflation and falling or at least stable interest rates, we can expect continued economic growth which will be positive for growth in corporate profits. Corporate profit growth is the ultimate driver of higher stock prices. Falling rates should provide a solid tailwind for stock prices. During September, the Dow and the S&P 500 Index reached record highs. Although the Fed initially misjudged how persistent inflation would be after the COVID pandemic, it has regained credibility as inflation has slowed without a recession.

Robust market performance can sometimes lead to a euphoria that encourages too much risk-taking. This should be avoided. Overweighting stocks may support returns, but unexpected volatility from any number of sources can spark shorter-term declines that go beyond one’s comfort level, triggering a desire to sell when prices are down rather than when they are up. On the other side, many investors may have taken a cautious stance expecting a recession when the Fed was pushing interest rates up so quickly. Less volatile investments like short-term CDs and Treasury Bills looked good in that world. Today’s environment with falling interest rates may provide a good opportunity to go the opposite direction, getting back to a prudent, diversified allocation between stocks, bonds, cash, and other asset classes.

David T. Mayes is a CERTIFIED FINANCIAL PLANNER ^TM professional and IRS Enrolled Three Bearings Fiduciary Advisors, Inc., a fee-only advisory firm in Hampton. He can be reached at (603) 926-1775 or david@threebearings.com .

This article originally appeared on Portsmouth Herald: Money Talk: Rate cut gives tailwind to stocks for Q4