Great expectations may need adjusting

Dave Gilreath: ©Dave Gilreath

Great expectations can lead to great disappointment. This this truism may apply to the stock market more than any other endeavor.

All through 2024 — the second year of the current bull market — many stocks received helpful impetus from the widespread expectation that elevated interest rates would decline significantly late in the year and into 2025.

But this hasn’t happened. The Federal Reserve board cut its benchmark rate, lowering all others, by one half of one percent in September and by one quarter of one percent Dec. 18, yet this is a slower pace of cuts than the market has long been expecting. Further, in announcing the quarter-point cut, Fed Chairman Jerome Powell signaled fewer cuts in 2025 than projected earlier.

Some analysts, including renowned market economist Ed Yardeni, has been saying for weeks that there’s really no need for the Fed to cut much because the economy is humming along nicely with elevated rates, with inflation declining. Now, the Fed board apparently agrees with Yardeni, so we’re probably entering a higher-rates-for-longer period.

The rate story

The rate story goes back to 2020, when the Fed slashed rates to near 0% to stimulate an economy wracked by the pandemic-induced recession. The resulting far lower cost of money enabled embattled businesses to get back on their feet after revenue shocks from pandemic shutdowns, with businesses closed and people staying home and not spending money in person.

After a brief bear period, the market starting ascending, optimistic about the positive effects of low, low rates on stocks. Prices also shot up, spurred by high post-pandemic demand. Belatedly concerned about rising prices, the Fed eventually started ratcheting up interest rates to cool the economy and tamp inflation down from levels not seen for 40 years — nearly 8%.

The Fed’s inflation target is 2% —a goal some economists say is unrealistically low and unnecessary. With inflation now between 2% and 3%, the Fed has made great progress toward the goal, though there are indications that inflation’s decline is also the result of organic forces, such as supply catching up with demand. Despite the progress, some inflation continues, chiefly on housing.

This scenario has caused some to doubt that the Fed will cut rates in 2025 anywhere near as fast or as deeply as originally expected, though consumer price index numbers released in mid-December encouraged the Fed to go ahead with the rate cut under consideration for that meeting.

Of course, these forecasts could prove inaccurate. The data-dependent Fed could end up cutting as quickly, or even faster, than originally expected.

But in the meantime, doubts persist about how much the Fed will cut as we enter the final year of the first quarter of the 21^st century. Recent data has prompted some members of the Fed’s board of governors to express opposition to significant rate-cutting in early 2025.

Thus, many investors are pondering two scenarios for 2025: one with cuts as rapid and deep as originally expected, and one with slower, shallower cuts.

No one can predict the market, although trends and shifts can often be anticipated by applying market history to current data and scenarios. Yet, when Covid hit, about 100 years had passed since the last pandemic (Spanish flu in 1918), and the current economy is far different. Thus, predicting still-lingering post-Covid impacts is extremely difficult. As Fed Chairman Jay Powell said several months ago, the aftermath of the pandemic is continuing to “write the story of the economy.”

If rates don’t decline significantly in 2025, this could mean a higher risk of a market pullback or correction. Of course, the risk that a growing market may correct is ever-present, but it is now relatively high from the markets having what’s known as multiple expansion —high price/earnings ratios, elevated by investor expectations of significant rate cuts. During growth periods, the market is always looking for a reason to correct, you might say.

Lower rates benefit public companies in various ways, chief among them is paying lower yields on bonds, enhancing profitability and earnings and making their stocks more attractive. Investors have driven up P/Es based on expectations of these benefits.

But if rates don’t come down significantly in 2025, it could take some of the air out of these elevated stocks, particularly tech companies and other momentum stocks. So, if you believe inflation will persist, causing the Fed to go light on interest rate cuts, loading up on such stocks may not be a good idea right now, with chances perhaps higher than usual for a pullback (perhaps a 5% decline) or a correction (10%).

Yet, at this point in the current bull market, an overall decline from delayed or shallow rate cuts would probably be nothing for investors to be terribly concerned about.

Rather, it would be a good buying opportunity, as growth would probably resume fairly soon. This is suggested by current momentum and earnings growth, indicating that this bull should continue to run through 2025.

Market redoubts

Even if upticks in inflation disincline the Fed toward more cuts, there will likely be some protective redoubts in the market. These include large-cap value stocks, which provide inflation-insulated yields through their dividend payouts. In this broad category, prospects in the coming months appear especially sanguine for financials, materials, real estate and utilities.

In addition to being fairly inflation-resistant, these sectors are likely to benefit from capital expenditures, which will probably grow in a regulatory environment that’s likely to loosen with more accommodating policies expected from the new Congress and presidential administration. Among these sectors, financials stand to benefit the most.

And regarding the stocks you already own, it’s usually a good idea to resist the urge to sell into overall market declines. The market should bounce back. It always has, rewarding long-term investors with the requisite patience and steadfastness to stay the course.

Dumping perfectly good stocks because of a little foul market weather usually turns out to be a poor choice. If these stocks were good purchases in the first place, it usually makes sense to hang onto them long enough to let them grow.

Dave Sheaff Gilreath, CFP,^® is a founder and chief investment officer of Sheaff Brock Investment Advisors, a firm serving individual investors, and Innovative Portfolios,^® an institutional money management firm. Based in Indianapolis, the firms are managing assets of about $1.4 billion, as of September 30.

Investments mentioned in this article may be held by those affiliates,Innovative Portfolios’ ETFs, or related persons.