Can lowering interest rates solve the "overvaluation risk" of US stocks and bonds?

The first rate cut by the Federal Reserve, known as the "big opening," has reignited expectations of avoiding a recession in the US economy, leading to further increase in the already high valuations of the US stock and bond markets. A model that adjusts the S&P 500 index returns and 10-year Treasury yields based on inflation shows that the current pricing levels of US stocks and bonds are higher than at the beginning of the previous 14 easing cycles by the Federal Reserve, which are typically associated with recessions. With the US stock market repeatedly hitting new highs, the total return of the S&P 500 index has exceeded 20% so far this year, indicating that regardless of how good the economic and policy news is this week, much of it has already been factored in by risk assets. Looking at the performance of major ETFs, US stocks and bonds are poised for a fifth consecutive month of gains, marking the longest simultaneous uptrend since 2006. In addition, investors are pouring funds into higher-risk corporate bonds, betting that lower borrowing costs will allow heavily indebted companies to refinance and extend maturities, thereby reducing default rates and supporting market valuations. However, a significant rate cut may not be able to prevent investors from entering a bear market. Spencer Jakab, a well-known journalist at The Wall Street Journal, wrote in a report on Saturday that if the economy is already starting to decline, then "Fed Chairman Powell really can't stop their investment portfolios from shrinking as people imagine." The initial response of the stock market to the rate cut on Wednesday was enthusiastic. However, this has often been proven to be an illusion - we still do not know the outcome of this performance. Citing a Goldman Sachs report, Jakab pointed out that if the economy was already in a recession before the first rate cut, the S&P 500 index would average a 14% decline over the next year. The 2008 financial crisis is still fresh in memory Taking the 2007 rate cut cycle as an example, after the first rate cut by the Federal Reserve, US stocks soared, with the Dow rising 336 points, the largest increase in more than four years, equivalent to about 1000 points today. Lehman Brothers' stock price performed the best, surging 10%. Coincidentally, the first rate cuts in 2007 and this time both occurred on September 18, with the federal funds rate starting at the same level, and the same reduction of 50 basis points. However, as we now know, the US stock market peaked just three weeks after reaching a bull market high, and in January 2008, panic selling began, less than a year before Lehman Brothers went bankrupt, becoming the largest bankruptcy case in US history. By that time, the Federal Reserve had cut rates six times, bringing rates to 2%, the lowest level in nearly four years. Within two months of the Lehman crisis breaking out, the Federal Reserve made three more significant rate cuts, bringing rates near zero (technically 0%-0.25%). Two months after the start of the rate cut cycle, market sentiment had already turned pessimistic, although a survey of 54 economists by The Wall Street Journal at the time showed only a one-third probability of the US economy entering a recession within the next 12 months. Jakab wrote that the Federal Reserve "has no magic wand" to save an economy or stock market already in trouble or about to fall into trouble. The rate cut is certainly important for bond investors. However, it may only temporarily alleviate the already emerging stock market downturn and take a long time to filter through to companies and consumers. "An economic growth trajectory can push the stock market up more than the speed of rate cuts," Goldman Sachs strategist David Kostin recently noted. If the economy was already in a recession before the first rate cut, the S&P 500 index would average a 14% decline over the next year. If the economy did not enter a recession, the opposite would be true. However, Jakab believes that there is currently no conclusive evidence that the US economy will quickly fall into a recession, and a significant drop in the stock market is uncommon when the economy is not clearly in decline. This helps explain why the stock market can maintain near historical highs and why the usual cautious sentiment in the market is not obvious. Furthermore, there is a misconception that the Federal Reserve's rate cuts are a reason to stay calm and continue investing, which also partly supports market sentiment. Focus on whether the labor market continues to deteriorate Jakab is not the only one concerned that a significant rate cut by the Federal Reserve may be too late. BlackRock researchers Amanda Lynam and Dominique Bly wrote in a recent report that due to the possibility of continued tightening of US monetary policy, market participants are also monitoring signs of worsening fundamentals, especially in floating-rate bonds. In addition, the two researchers pointed out that although CCC-rated corporate bonds have performed well, overall they still face pressures. Compared to interest expenses, the total income levels of these companies are relatively low. The borrowing costs for CCC bonds are still around 10%, and for some small companies, they have to refinance after the end of the era of easy money, putting them in a difficult situation. Even as interest rates fall, they face default risks. JPMorgan analysts Eric Beinstein and Nathaniel Rosenbaum wrote in a research report last week that any signal of weakness in the labor market "will have a negative impact on spreads, as it will exacerbate concerns about an economic recession and lower yields." This article is reprinted from "Wall Street News", edited by GMTEight: Jiang Yuanhua.