Do Rate Cuts ACTUALLY Send Stocks Higher?

this video is sponsored by brilliant visit brilliant. org theplan bagle or click the link in the description to get a free 30-day trial plus 20% off an annual premium subscription greetings everyone welcome to the plane Bagel I'm your host Richard coffin after years of grappling with higher interest rates to try and cool inflation it's seeming increasingly likely that the Federal Reserve is due to cut interest rates by the end of September with latest labor and inflation figures seemingly pointing to a cooling economy which many believes haves the way for for the Federal Reserve chair Jerome Powell to begin easing the restrictive monetary policy of the Central Bank and for many investors especially those online the anticipation is electrifying with markets seemingly waiting on the edge of their seats for the prophesized moment where Jerome Powell walks across that stage to his Podium and declares those magic words the Federal Reserve is paying interest rates now to be sure Ray Cuts taken by themselves are generally considered to be stimulating for the economy it's why they're considered part of expansionary policy and the federal funds rate is a pretty important Benchmark not only because it can impact domestic us loans and the interest rates charged internally but given the she size of the US economy their stock market and the dominance of the US dollar globally it also impacts other countries in the policies they end up pursuing such as uh here in Canada so given all this you'd probably expect that when a ray cut finally occurs uh that stocks will surely Skyrocket and and markets Will Rejoice but is that actually the case uh do stocks historically actually rise after a rate cut announcement well if you try to Google that to find the answer the results are a bit more mixed than you might expect you'll likely find some articles that give the theoretical answer that yes because rate cuts are good for the economy stocks do rise after a rate cut is announced or you might find a few blog posts that are good that no in fact the S&P 500 historically has actually Fallen by an average of 23% after rate cut has been announced and for today's video I wanted to clear up that answer the only way I know how Excel spreadsheets uh to try and get to the bottom of what rate Cuts actually historically have meant for the markets I looked over the last 40 Years of rate cut Decisions by the Federal Reserve to try and ascertain how this expansionary policy impacts stock market performance how with me looking at both the S&P 500 which focuses on large cap US Stocks as well as the Russell 2000 which covers small cap stocks so we can see how both react to rate cut announcements but before hopping into the dark secrets held within my sheets it's worth going over the theory of why investors believe Cuts can lead stock prices higher now if you want to skip this section rude uh but I'll leave chapters in the description so you can hop ahead if you already have a solid understanding of how rate Cuts impact the economy but let's start with the basics of rate Cuts as you might know when we talk about rate Cuts we're specifically talking about the reduction of a central bank policy rate uh which in the United States is called the federal funds rate uh which is simply a very short-term Loan in fact overnight loans uh taken between Banks amongst one another and it's a rate that the Federal Reserve is able to influence higher or lower with using Target rates to indicate the range within which it wants the effective rate to operate within and the idea is that as the interest rate for the short-term loans goes up or down that should eventually impact other loans within the economy as Banks themselves face for example a lower interest rate for their short-term loans eventually they might go and charge lower interest rates for their mortgages and their car loans uh which broadly speaking is seen as something that will bolster economic activity uh for a number of reason reasons for one consumers are incentivized to save less money and and borrow and spend more given that interest rates for both loans and savings accounts should fall corporations themselves will see a lower cost of debt which uh can increase their profits and likewise incentivize them to pursue more projects and Investments whether it be new Ventures or just expansions and finally governments themselves might face a lower cost of debt which likewise as another player in the economy might incentivize them uh to pursue uh more spending and all this should lead to higher stock prices right as companies start reporting better and better earnings from more consumer demand and higher profitability it should lead to their stock price increasing since uh the company's profits plays a role in how they're valued but on top of companies actually seeing better results lower interest rates should in addition to that theoretically cause stock valuations to expand uh meaning that not only will companies become more profitable but investors should value those profits by a higher amount u meaning that in other words if a company saw flat performance they should still see their stock price increase as their valuation multiple expands for example if you graph the S&P 500 PE ratio which represents how much investors are willing to pay per dollar of annual profit from the company you can see that generally tends to move inversely to the federal funds rate and by extension the 10-year treasury yield which is a benchmark for longer term loans it might be confusing why investors seem to randomly start paying more for stocks when interest rates start to fall but there is a sound explanation for it because as interest rates decrease it actually decreases the opportunity cost of making an investment uh basically because things like saving accounts and fixed income investments will offer a lower return to investors as their rates fall uh so you buy a bond will pay you a lower and lower return uh it makes more investors likely to pursue investments in stocks uh to try and get a better Roi on their money which will push up valuations for stocks as more people go and buy those investments in fact if you're familiar with the discounted cash flow model which is a way to uh calculate the value of a stock if you can forecast its future cash flows it's an impact you can actually calculate because the discount rate which is how you discount the future cash flows uh basically how much investors will value a cash flow in the future the discount rate will fall with interest rates meaning that those future cash flows become more and more valuable now if you're getting a bit loss in the Wheats here don't worry the main takeaway here is that there's there's two reasons a double whammy in a good way as to why stock prices should increase when rate Cuts occur the first being that stocks become more profitable or the underlying companies earn more money and the second being that investors should value those profits by a larger amount they should apply a higher dollar price tag per dollar of profit that a company earns so you should expect markets to do well when rates start to fall but historically is that what actually happens to the spreadsheets since 1984 which is around the time the Federal Reserve started to solidify its Target rate policy approach for the Central Bank policy rate there have been eight rate cut campaigns which I Define in this case as a period of time where the Federal Reserve is carrying out mostly uninterrupted Ray Cuts with me using the threshold of three consecutive rate Cuts or hikes totaling at least 50 basis points or half a percentage point to Mark the respective start and end of a given campaign now for each of these campaigns the first Ray cut is arguably the most important and the likely the area we should focus on when trying to calculate the impact of Ray cut campaigns on the stock market and I calculated the return of the S&P 500 starting with uh the open of the market on the day that the rut was announced over four different time periods the one day return so how much markets jumped on the announcement of the rate cut occurring the one month or 30-day return the onee return from the First Rate cut and the return from the first day of the rate cut campaign to 30 days after the last rate cut of that campaign as since some of these campaigns actually lasted longer than a year now unfortunately there's not a crazy amount of data for us to explore here with only eight campaigns because before 1982 the Federal Reserve didn't really explicitly share targets around the federal funds rate and how they managed their monetary policy was very different from how they do so today with the rate historically moving up and down a lot more than it does now which is why why we're excluding any period before 1984 on top of that we also have to exclude some of the one-day returns from our data set given that the Federal Reserve only started being transparent with its rate cut decisions starting in 1994 but acknowledging these limitations how did the S&P 500 actually perform after the First Rate cut of each campaign well starting with the one- day return you can see that we actually have a pretty high average performance of 1. 6% which might not sound like a lot but if you annualize it meaning that you assume you could earn that every day you can see it's pretty good but once you get to the longer time Horizons Things become a little less attractive with the annualized return for the 30-day and one-year period sitting between 7 and 8% which isn't that bad but likewise isn't all that exceptional and the return for the entire campaign plus that 30-day buffer sitting at an annualized 10% which again is not bad but perhaps a little less than expected given how seemingly sacred the rate cut event is and when you switch gears to the Russell 2000 to see how smaller companies perform the returns are actually quite disappointing outside the one-day return which again does seem to show a positive bump the long-term results only range from an annualized 2.

4% to just 5. 4% now so far we have to add an asteris to these returns to highlight that we've only been looking at the price Return of the markets uh but as you know investors earn both the price return and the dividend yield of the stocks they own so when you look at the total return for the S&P 500 unfortunately you couldn't get the same data for the Russell 2000 you can see that comparatively the dividends do bump up those return figures by roughly 2% but even still the one-year return figure for example remains pretty lackluster with really just sitting around the long-term average return figure of the S&P 500 which might lead you to the conclusion that while Ray cuts are great in the short term when they're first announced they seem to lose their luster over a longer period of time but here it's worth considering that one uh we're again dealing with a pretty limited data set and two you can see that the average return we've calculated doesn't really reflect the fact that there's a pretty wide range of historical outcomes here the annual War return for example has ranged from a positive 22. 3% in the 1998 campaign to negative 17.

8% during the 2007 campaign the returns are also heavily skewed by just a few outliers such as for example the full campaign return the annualized figure drops to just 1% when you exclude the 1998 campaign because it was a relatively short campaign that saw relatively strong performance and just overall outside that one-day return period where there does seem to be a somewhat consistent positive bump it doesn't see seem like R Cuts actually have that defining of an impact on stock market performance the outcomes seem to be all over the place which might lead to some questions after all we have again some solid theory about why rate Cuts should matter and there is a lot of evidence that rate Cuts do have a meaningful impact on the economy so what's going on here why don't stocks necessarily reflect this well there there's likely three kind of main reasons with the first being that markets are forward-looking and often times by the time a rate cut actually occurs markets are already already expecting it so perhaps while an announcement of a rate cut does eliminate the risk of that not occurring and does lead to that small boost uh by this point markets have already likely been trading stocks at a valuation that reflects a lower rate environment uh and it doesn't necessarily matter whether a rate cut actually occurs or not but whether Federal Reserve policy ends up being more or less expansionary than initially expected now the second thing to highlight is that rate Cuts do take time to influence how the economy will perform and does take time to influence other interest rates in the economy while shorter term loans might move more quickly towards where the federal funds rate is uh longer term loans like mortgages can take more time and be influenced in the short term by supplying Dem man factors uh for example if you actually graph the federal funds rate against the 10-year treasury yield which is a benchmark for longer term loans there's often a leg between when the federal funds rate moves and the yield follows which can lead to these periods like we've seen over the last 12 months more shorter term loans actually charge a higher interest rate than longer term loans uh meaning that despite what the Federal Reserve might be trying to achieve you can have the discrepancy with how that actually impacts economic activity given that the treasury yield matters as a benchmark more for longer term loans which leads us a little bit to the last point which is that quite frankly the federal funds rate might not be as important as a lot of investors expect and there are simultaneously many other factors influencing market performance that might matter more for example research by truist advisory Services highlights that stocks do typically rise in the 6 to 12- month period following the fed's First Rate cut but only generally when the economy avoids a recession and sure enough if you take our own figures you can see that the one-year return is pretty consistently worse when a recession does occur after a ray cut campaign versus when it's avoided on top of that while Ray cuts themselves might be a benefit to the economy and stock market performance you have to consider why they're being carried out the Federal Reserve doesn't just cut rates because Jimmy's portfolio only earned 6% this year rates are often cut to offset other negative factors that are dampening economic activity uh so while you might have this positive benefit of a rate cut that's uh in a way bolstering activity you simultaneously are only seeing that applied when there's negatives that might be pushing the economy towards a recession in fact the last three rate cut campaigns that we've seen in the United States all occurred because of or were followed by some form of economic crisis including the Doom crash the 2008 financial crisis and the covid-19 lockdowns I'll be there we had already seen the rate cut start before the onset of the pandemic so while investors might expect strong stock performance when we enter a rate cut campaign and again the one day return does seem to suggest uh that there might be that sort of one-day jump on the first announcement perhaps more important than the occurrence of a rate cut is why the rate cut is occurring now none of this is to say that rate Cuts don't matter for stock prices obviously this is a very limited study uh and rate Cuts might mean things for different companies and certainly different sectors but it might be dangerous to assume that raets will always be followed by this sort of broad-based strong performance especially given that we only typically see rate cuts to try and offset the occurrence of things like a recession or otherwise dampened economic activity especially this time around there are other factors that need to be considered when looking at how stocks are going to perform for example stock valuations are already near their historical High government spending and debt are already elevated and the yield curve already has longer term loans with a lower interest rate than shorter term loans meaning a lot of the economy is still operating in a low interest rate longer term environment so unless we see rates cut by more than expected uh for the longer term it's likely that other factors like consumer Trends technological developments business strategy environmental factors government policy and geopolitical developments will all collectively play a much bigger role in determining where stocks Go versus a federal funds rate cut and as usual it does all seem to point to the common conclusion we come to on this channel uh which is that it's really difficult to try and play these sort of short-term events and that for most people you're better suited focusing on the long term rather than just praying for drone pow announcement so hopefully this video helped to explain a few things around rate cuts and if you like the numbers you like diving into stats and want to learn more about understanding data today's video was sponsored by brilliant and I definitely think you should check them out if you want to expand your learning as you may or may not know one of the best ways to learn is through active participation u meaning that rather than just listening to someone talk at you for an hour or so uh you actually work through a concept through exercises and activities uh it's something that I actually personally came to appreciate when I had a teaching role in University it was something that I was taught to try and imp Implement and it's why I think brilliant has a really unique offering brilliant is a platform that offers interactive lessons on a number of different subjects with each lesson including Hands-On activities that help to teach you the concepts and the lessons are bite-sized meaning that you can dedicate just a few minutes a day to learning a topic and conquering a subject for example if you keep hearing people talk about Ai and uh feel like you're left out for not knowing what a pre-trained Transformer is uh they have a course on large language models which is the type of model used by AI text generators like chat gbt and they have plenty of other courses on the topics of math data computer science and science science and the best part of brilliant is that you can try it all today for free you can just visit brilliant.