The Federal Reserve's first rate cut, known as &#34;opening up big,&#34; has reignited expectations for the U.S. economy to avoid a recession, leading to a further increase in the already high valuations of the U.S. stock and bond markets.
A model that adjusts the S&amp;P 500 index yield and the 10-year U.S. Treasury yield based on inflation shows that the current pricing level of U.S. stocks and bonds is higher than at the start of the previous 14 easing cycles by the Federal Reserve, which are usually associated with recessions.
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With the U.S. stock market repeatedly hitting historic highs, the total return of the S&amp;P 500 index has exceeded 20% so far this year, indicating that many of the positive economic and policy news this week have already been absorbed by risk assets.
Looking at the performance of major ETFs, U.S. stocks and bonds are expected to achieve five consecutive months of gains, the longest simultaneous uptrend since 2006. In addition, investors are pouring funds into higher-risk corporate bonds, betting that the decline in borrowing costs will allow heavily indebted companies to refinance and extend their maturity dates, thereby reducing default rates and supporting market valuations.
However, a significant rate cut may not be able to prevent investors from falling into a bear market. In a report on Saturday, Spencer Jakab, a well-known journalist at The Wall Street Journal, wrote, &#34;If the economy is already in recession, then 'Fed Chairman Powell really can't stop their investment portfolios from shrinking' as people imagine.&#34;
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The initial reaction of the stock market to the rate cut on Wednesday was enthusiastic. However, this is often proven to be an illusion—we still do not know the outcome of this drama.
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Jakab cited a Goldman Sachs report indicating that if the economy was already in recession before the first rate cut, the S&amp;P 500 index could average a 14% decline in the next year.
<h2>The 2008 Financial Crisis Still Fresh in Memory</h2>
Taking the 2007 rate cut cycle as an example, after the Federal Reserve's first rate cut, the U.S. stock market soared, with the Dow rising by 336 points, equivalent to around 1000 points today, marking the largest increase in over four years. Lehman Brothers' stock price performed the best, surging by 10%. Coincidentally, the first rate cut in 2007 and the current rate cut both occurred on September 18th, with the same initial federal funds rate and the same 50 basis point cut.
However, as we now know, just three weeks after the U.S. stock market reached its bull market peak, panic selling began in January 2008, and less than a year later, Lehman Brothers went bankrupt, becoming the largest bankruptcy case in U.S. history. By that time, the Federal Reserve had already cut rates six times, bringing rates down to 2%, the lowest level in nearly four years. Within two months of the Lehman crisis outbreak, the Federal Reserve made three more significant rate cuts, bringing rates close to zero for the first time (technically 0%-0.25%).
Two months into the rate cut cycle, market sentiment had already turned bleak, but a survey by The Wall Street Journal of 54 economists at the time showed that the likelihood of the U.S. economy entering a recession within the next 12 months was only one in three
Jakab wrote, &#34;The Federal Reserve has no magic wand to rescue economies and stock markets that are already in trouble or about to fall into trouble.&#34;
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Rate cuts are certainly important for bond investors. However, they may only (temporarily) alleviate the existing stock market downturn, taking a long time to filter through to companies and consumers.
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In contrast, &#34;the trajectory of economic growth is more capable of driving stock market gains than the speed of rate cuts,&#34; Goldman Sachs strategist David Kostin recently pointed out, &#34;If the economy has already entered a recession before the first rate cut, the S&amp;P 500 index will average a 14% decline in the next year.&#34; If the economy has not entered a recession, the situation is quite the opposite.
However, Jakab believes that there is currently no conclusive evidence that the U.S. economy will quickly fall into a recession, and significant stock market declines are uncommon when the economy is not clearly in recession.
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This helps explain why the stock market can maintain levels close to historical highs, and the usual cautious sentiment in the market is not evident. In addition, there is a misconception that the Fed's rate cuts are a reason to stay calm and continue investing, which to some extent also supports market sentiment.
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<h2>Focus on whether the labor market continues to deteriorate</h2>
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 as U.S. monetary policy may continue to remain tight, market participants are also watching for signs of deteriorating fundamentals, especially in floating rate bonds.
Furthermore, the two researchers pointed out that despite the strong performance of CCC-rated corporate bonds, they still face overall pressure.
Compared to interest expenses, the total income levels of these companies are low. The borrowing costs of CCC bonds are still around 10%, and for some small companies, they have to refinance after the end of the era of loose monetary policy, putting them in a difficult situation. Even with lower interest rates, they face default risks.
JP Morgan analysts Eric Beinstein and Nathaniel Rosenbaum wrote in a research report last week that &#34;any signs 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.&#34;

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Taking the 2008 financial crisis as a lesson, if the United States has already entered or is about to enter a recession, even a significant rate cut cannot prevent the arrival of a bear market. According to the latest research report from Goldman Sachs, if the economy has already entered a recession before the first rate cut, the S&P 500 index is expected to decline by an average of 14% in the next year

- The Federal Reserve's first rate cut has heightened expectations of avoiding a recession, leading to increased valuations in U.S. equity and bond markets.  
- A model indicates that current pricing levels exceed those at the start of previous easing cycles, with the S&P 500's total return surpassing 20% this year.  
- Concerns remain that significant rate cuts may not prevent a bear market, as historical patterns suggest potential declines if the economy is already in recession.

Can rate cuts solve the "overvaluation risk" of US stocks and bonds?