In the run-up to Friday’s employment data, investors grew excited about the prospect for weak numbers, knowing that such an outcome could push the Federal Reserve to cut interest rates.
Indeed, interest-rate futures point to a 100% probability of a rate reduction at the Fed’s meeting Sept. 15-16.
A rate cut could boost stocks by sparking economic expansion and thus lifting earnings growth. That view led investors to push stocks higher, with the S&P 500 (NYSE: SPY) rising a hefty 2.7% in the one-month period ending Thursday. This thinking could turn out to be correct.
Investors got their weak employment numbers Friday. Non-farm payrolls gained only 22,000 in August, and the unemployment rate climbed to 4.3% from 4.2% in July.
Enthusiasm may be dashed
But those statistics didn’t lead to a stock-market rally. The S&P 500 slipped 0.5% as of midday Friday. And there are some good reasons why stocks might decline, despite falling interest rates. Of course, it’s no slam dunk that equities will slide, they could easily ascend instead. But here are the strongest arguments for a fall.
- First, the Fed would be cutting rates because of slow economic growth. GDP slid 0.5% annualized in the first quarter, though it did rebound 3.3% in the second quarter. Both quarters were distorted by tariff effects. In any case, slower economic growth means slower earnings growth. And there is no guarantee that interest-rate cuts will produce stronger economic growth, especially in the short term.
- Second, inflation hasn’t gone away, as high tariffs are helping to push prices higher. The Fed’s favored inflation indicator, the personal consumption expenditures price index, rose at a 3.3% annual rate in the second quarter. That’s far above the Fed’s target of 2%. And lower interest rates could pull inflation higher. As you know, inflation is bad for stocks, raising companies’ costs and lowering the value of their assets.
- Stocks already are richly valued. As of Aug. 29, the forward 12-month price-earnings ratio for the S&P 500 registered 22.4, well above the five-year average of 19.9 and the 10-year average of 18.5. Nobel laureate Robert Shiller’s cyclically-adjusted PE ratio, which accounts for 10 years of earnings, is at its second highest level since 1871. It trails only the dot-com boom of 1999. With stocks so high, it might not take much more economic weakness or inflation to send them reeling.
To be sure, it’s no sure thing that stocks will drop from here. The market is a fickle beast, and often confounds expectations. Still investors may want be wary of jumping on the bullish bandwagon too quickly.
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