Your 401(k) has 'room to run.' And it's not all about Fed rate cuts.

The stock market has appeared to follow a crude pattern in recent months.

It looks something like this: See the Fed predict more interest rate cuts than expected.

See the market soar.

The dynamic held to form last week when the Federal Reserve stuck to its forecast of three rate cuts this year despite a worrisome inflation pickup in January and February. The S&P 500 index has jumped 1.1% since the Fed’s announcement midday Wednesday and closed at 5,234 Friday, just off the previous day's record high.

But there’s a bit more nuance to what looks like a knee-jerk response to the financial rocket fuel of low interest rates, analysts say. The outlook for the U.S. economy and corporate earnings has brightened considerably in the past few months. Investors like that narrative even more than they like low interest rates.

“I think the market is focused more on earnings and the economy than the Fed,” says Chris Zaccarelli, chief investment officer of Independent Advisor Alliance.

And that means the market's rally since autumn could have legs, a development that would further lift Americans’ 401(k) balances and other investments this year even after an already big run-up.

“I think it’s got more room to run,” Zaccarelli says.

Why is the stock market going up?

There’s little doubt the Fed’s median estimate Wednesday of three rate cuts in 2024 propelled stocks higher last week. After the inflation flare-up early this year, many economists figured officials would scale back their forecast to two cuts to ensure consumer price increases are subdued before lowering rates sharply. Fed Chair Jerome Powell suggested the price spike could be a blip and officials will monitor the data closely in the coming months.

But Fed officials last week also predicted the economy will grow 2.1% this year, down from a robust 3.1% in 2023 but well above their 1.4% forecast in December. Consumer spending and job growth have been surprisingly resilient despite high borrowing costs and prices, largely as a result of healthy pay increases. The Fed's more bullish view also drove up stock values, Zaccarelli says.

What is the corporate earnings forecast for 2024?

Meanwhile, earnings of S&P 500 companies are projected to grow 10.9% in 2024, according to FactSet. That’s up from low single-digit increases last year, a leap that can partly be traced to the resolution of pandemic-related supply chain snarls and faster growth in productivity, or output per worker, says Ryan Detrick, chief marketing strategist of Carson Group, an investment firm.

On the surface, it may look like the stock market is all about the Fed and interest rates. Wall Street likes lower borrowing costs for consumers and businesses because they spur faster growth, which should boost corporate profits. Lower rates also coax investors to move money from bonds that now have lower returns to higher-yielding stocks.

Last fall, as inflation eased substantially, stocks took off, largely in anticipation of faster Fed rate cuts. The rally picked up steam when the Fed upped its 2024 forecast from two to three cuts in mid-December. The S&P 500 index is up 26.6% since inflation began slowing and has gained 10.3% this year.  

But even in February and March, as a key inflation measure, the consumer price index, showed an acceleration in price increases in the first two months of the year, the S&P 500 largely shrugged off the concerns and continued its march higher.

Is the U.S. going to have a soft landing?

Sure, the Fed’s rate forecasts are having an impact. But Detrick called it “the cherry on top” of an improved economic and earnings picture. There’s a growing belief among forecasters that the Fed will achieve a “soft landing” in which it stamps out high inflation without triggering a recession.

Put another way, if the Fed winds up chopping rates six times instead of three, as some economists expect, that will mean the economy is teetering or in recession "and the stock market is going to go down," Zaccarelli says.

Overall, though, the prospect of both a solid economy and steady rate cuts is unusual and makes for a favorable environment for investors.

What causes interest rates to rise?

Traditionally, the Fed raises interest rates to squelch inflation by lifting borrowing costs for consumers and businesses, thus curtailing economic activity.

From March 2022 to July 2023, the central bank hiked its key rate from near zero to a 23-year high of 5.25% to 5.5%. Annual Inflation hit a four-decade high of 9.1% in mid-2022 because of COVID-related product and labor shortages but has since fallen to about 3%. That’s still above the Fed’s 2% goal.

Why does the Fed cut rates?

The Fed typically trims rates to stimulate a flagging economy or dig it out of a recession. But lower rates probably wouldn't do much for stocks if the economy and corporate earnings were foundering, Detrick and Zaccarelli say.

Now, though, the Fed plans to shave rates not to jolt the economy but to bring rates closer to their long-run average since inflation is getting close to normal. Otherwise, inflation-adjusted rates would restrain the economy more than needed.

Since 1984, when the Fed slashed interest rates to nudge them back to normal after a flurry of rate hikes, the S&P 500 index has climbed an average of 13.2% in the following 12 months, according to Detrick’s analysis.

By contrast, when the central bank has reduced rates to head off – or rescue the economy from – a downturn, the benchmark stock index has fallen an average of 11.6% in the following 12 months.

Is it a bad idea to invest in stocks right now?

Despite the positive backdrop, there are still notable risks for investors.

“The biggest risk is the Fed keeps rates too high for too long” and the economy slips into recession, Zaccarelli says.

Also, stock prices are historically high at 20.9 times expected earnings over the next 12 months, according to FactSet. That compares to a five-year average earnings multiple of 19 and a 10-year average of 17.7. In other words, stocks are pricey and could be poised for a correction.

Detrick, though, notes that prices were 35 to 40 times earnings in the late 1990s, adding, “Valuations are high but they’re not astronomically high.”

After setting an all-time record in January 2022, the S&P index sold off on skyrocketing inflation and Fed rate hikes and didn’t return to, and then top, that peak until this past January, he says, suggesting equities are still making up for lost time.

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In a note to clients, Ned Davis Research said high valuations aren't an obstacle to the rally "as long as earnings growth remains strong.”

Detrick thinks the market could rise another 5% to 8% this year but he's avoiding Big Tech shares and likes small cap stocks that have been hobbled most by high rates and are poised for a rebound.

Zaccarelli says another 10% advance in the broad index is feasible as long as the economy doesn’t topple into a recession.