by Joe Herrle, CFA
Vice President, Alternative Assets
The world of investing is welcoming a new generation: Gen Z. A recent study by the FINRA Foundation and the CFA Institute found that a whopping 56% of Gen Z are already invested, with many starting younger than any generation before them. This tech-savvy group is also turning to social media for investment information, making their approach quite different from those of us who entered the market during or after the Great Financial Crisis (GFC).
A key distinguishing feature of markets between the era of the financial crisis circa 2008 and the era of COVID was ultra-low interest rates. And one of the defining investment mantras for millennials like me who graduated in the wake of the GFC, has been "Don't fight the Fed." This meant understanding markets often react positively to anticipated Federal Reserve policy changes, particularly interest rate cuts.
There are a couple of reasons for this reaction. The most straightforward is that lower interest rates make borrowing cheaper, stimulating economic activity. This, in turn, could lead to higher stock prices. Another answer has to do with discounting and the Capital Asset Pricing Model; essentially, the math of valuing stocks. I will spare you all of the gory details, but to summarize, all things being equal, the formula calls for lower stock prices as market interest rates increase.
However, there's a crucial element to this equation that's often overlooked: earnings. While Fed policy can certainly influence the market in the short term, long-term returns are primarily driven by corporate earnings growth. Here's where the "Don't fight the Fed" mentality can be misleading.
Think about it this way. Since the Fed began raising rates in March 2022, a move that traditionally puts downward pressure on stock prices, the S&P 500 has actually returned nearly 15%. This defies the low-rates-equal-high-returns narrative.
What can explain the disconnect? Because earnings have remained resilient. Companies have continued to deliver strong profits, exceeding expectations throughout 2024. This highlights a key point: the reason for rate changes is often more important than the rate changes themselves.
The Fed raises rates when the economy is strong and vice versa. Rising rates often signal a healthy economic environment with robust employment and expanding corporate margins—all positive signs for the stock market. These elements have led to inflation readings that remain over the Fed’s 2% target (although the inflation rate shows signs of declining). This is why expectations for rate cuts in 2024 have shrunk from six to just one-to-two. It is also why we remain favorable on the outlook for equity markets this year.
Here's some data to back this up. Since 1990, when interest rates are rising, the average one-year return for the S&P 500 is a healthy 13.9%. Conversely, when rates are falling, the average return dips to just 6.5%.
The takeaway? Don't get caught up in the daily noise surrounding Fed policy. While it can cause short-term market movements, long-term success hinges on a company's ability to generate profits. Remember, it's earnings, not interest rates, that truly drive the market. That’s why I propose a new mantra for my generation of investors: “Don’t fight earnings.”
Takeaways for the Week:
The S&P 500 reached an all-time high on Tuesday as we near the end of the first-quarter earnings season
Nvidia's shares soared to record highs after the company's strong earnings forecast signaled unwavering demand for its AI chips. Nvidia's stock jumped over 10% on Thursday following the earnings report