After peaking on October 28 and seeing a more than 5% mild pullback into late November, the S&P 500 moved back to new all-time highs on Thursday of last week. A positive reaction to the Federal Reserve (Fed) cutting rates sparked the recent rally (more on that below), but it is important to remember that after a 38% rally off the April lows, some type of weakness in November was perfectly normal and even healthy, as we noted at the time.
What stands out about the recent new highs is how broad based they’ve been. Areas like micro-caps, small caps, midcaps, the Equal Weight S&P 500, and the NYSE Composite all hit new highs last week. We’ve pushed back repeatedly on the idea that this market was top-heavy and only led by a few large technology names. It wasn’t ever true. Even with tech and AI names weak last week, we have been quite encouraged to see the baton passed to other areas of the market. As we like to say, the lifeblood of a bull market is rotation, and we are clearly seeing that.
Time for a Santa Rally?
As we noted earlier this month, December is indeed historically one of the stronger months of the year, with gains more than 73% of the time. No month is more likely to be higher, and when 2025 is said and done, we think the S&P 500 has a good chance of seeing gains the second half of this month. December gains typically happen more in the back half of the month, and late-December strength is perfectly normal. Here’s what the average December since 1950 looks like, with gains tending to happen in the latter part of the month as we get closer to the holidays.
Don’t Fight the Fed
The Fed cut interest rates for the third time this year last week. Below, we will get more into the weeds of it all, but the bottom line is this cut took place near all-time highs, which could have the bulls smiling.
We found 22 other times the Fed cut interest rates when the S&P 500 was within 2% of an all-time high (based on the prior day’s close), and stocks were higher a year later 22 out of 22 times and up more than 14% on average. “Don’t fight the Fed” is an old Wall Street saying, and we think there’s some genuine truth to it. If the Fed is hiking (like in 2022), then there can be headwinds, but if they are dovish (like now), that very well could be a tailwind for investors in 2026.
The Fed Comes Bearing Gifts
The Federal Reserve cut rates once again last week, taking its policy rate down to the 3.50-3.75% range. This was as expected, but the chatter before the meeting was that this would be a “hawkish cut.” We don’t think it was, and we’ll explain why below, but bigger picture, it’s hard to say a cut is hawkish when it comes on the back of a slew of rate cuts:
- The Fed has now cut 0.75 percentage points over the last three months.
- The Fed has cut 1.75 percentage points over the last 15 months.
The Fed has taken the policy rate from the 5.25-5.50% range to 3.50-3.75% over the last 15 months. Meanwhile, already elevated inflation has moved sideways. The Fed’s preferred measure of inflation, the core Personal Consumption Expenditures Price Index (PCE), is up 2.8% year over year, exactly where it was 15 months ago. It’s hard to view these kinds of rate cuts as anything but dovish, despite elevated inflation.
While the Fed did push through a cut at this meeting, the vote was not unanimous. There were three dissents (the vote was 9-3 in favor of the cut):
- Two dissents were in favor of no cut: Austan Goolsbee (Chicago Fed President) and Jeff Schmid (Kansas City Fed President).
- One dissent was in favor of a larger 0.50 percentage point cut: Governor Stephen Miran (who is on “loan” from his role in the White House as Chair of the Council of Economic Advisors).
Three dissents is quite notable and different from how the Fed’s been operating recently, especially under current Fed Chair Jerome Powell. Since 1993, only five meetings have had three dissents, with the most recent coming in 2019 (in September 2019, three members voted against a rate cut of 0.25 percentage points).
Now let’s dig into why the Fed’s signaling tilted dovish, especially relative to expectations going into the meeting.
The Fed’s Worried About the Labor Market
The reason the Fed has cut as much as they have over the last 15 months, let alone the last three months, is that they’re worried about the labor market. They believe the risks to their two mandates—stable and low inflation and maximum employment—are in opposition. Risks to inflation are tilted to the upside while risks to employment are tilted to the downside. And since the policy rate was well above “neutral” (the rate that is neither too tight nor too accommodative), it only made sense to move the rate lower and closer to that neutral rate.
Of course, Powell also said that it’s a close call when the two sides of the Fed’s mandate are in opposition, which is the source of dispersion of views across the committee, as each member weighs the risks differently.
Powell clearly thinks job growth is weak. The average monthly job growth since April has been about 40,000/month, but he thinks that’s an overcount and the actual number has been about 20,000/month. He’s likely basing this off the fact that job growth has been revised sharply lower over the last two years. At the same time, he noted that the supply of workers is low (mostly due to low immigration), and so hiring is bound to be low as a result. Even if we’re not there yet, an environment with negative job growth would be something to be careful about, and Powell said that they want to make sure Fed policy is not pushing down job creation even further.
On the inflation front, Powell noted that tariffs have pushed up inflation this year. But he is encouraged that services inflation is pulling lower, mostly on the back of housing disinflation. I’d argue that core services ex housing inflation is still running hot, but the Fed is clearly looking past this.
Looking ahead, Powell pointed out that they’ve already reduced rates a lot, and we’re poised to receive a lot of economic data between now and the Fed’s January meeting, so they’re going to be in “wait and see” mode. In fact, fed funds futures are now pricing in just a 22% probability of a cut at the Fed’s January meeting.
The “Dot Plot” Leans Dovish
The Fed’s Summary of Economic Projections (SEP), which includes rate outlook forecasts (aka the “dot plot”), signaled a dovish outlook. The SEP, updated every three months, contains members’ projection of future policy rates and economic data like real GDP, unemployment, and inflation.
While we had only two formal dissents to the Fed cutting rates, according to the dot plot, six members disagreed with the Fed’s decision. There were four “soft dissents” in addition to the two “hard dissents” (the two members who voted no), as these six members projected a higher policy rate of 3.9% for the end 2025, above the policy rate of 3.6% that we’re at after the December cut. Still, this is a minority of the 19-member committee (though only 12 vote in any given meeting). A comfortable majority of those 12 were on board with taking rates lower.
Perhaps more importantly, the signaling for 2026 leaned dovish.
- The median member projected one rate cut in 2026.
- Seven members projected no cuts in 2026 (including three who projected a hike).
- Four members projected one rate cut in 2026.
- But a plurality of eight members projected two more rate cuts in 2026.
You can see why the Fed leans toward the side of cutting rates, with eight members expecting two or more cuts next year. Plus, President Trump is going to nominate a new Fed Chair who will likely be amenable to more rate cuts (Powell’s term ends in May).
The Fed Is Optimistic About the Economy and Productivity
The dot plot leans toward rate cuts, but for context, it’s important to look at the economic projections, too. This helps tell us the Fed’s “rationale” for expecting more rate cuts, especially whether it’s for “bad” reasons (to protect the labor market) or for “good” reasons (economic growth on the back of productivity growth).
The biggest change, relative to September, was projections for real GDP growth:
- 2025 was upgraded from 1.6% to 1.7%.
- 2026 was upgraded from 1.8% to 2.3%.
The upgrade to 2026 real GDP growth is a huge shift, and it’s the highest GDP growth projection they’ve ever made for 2026 (going back to December 2023). Powell pointed out that consumer spending is holding up, even as AI-related data center spending is boosting business investment, which is why they’re expecting a pickup in growth next year, especially as the tariff headwind fades.
Even by itself, an upgrade to GDP growth while cutting rates (and projecting still more cuts) is dovish. Fed members also projected slightly lower inflation (core PCE) than in September, with both 2025 and 2026 projections falling a tick to 3.0% and 2.5%, respectively. They still expect inflation to run above target for the next couple of years, but it’s notable (and dovish) that they project declining inflation even as they’re cutting rates.
Finally, let’s look at projections of the unemployment rate in 2025 and 2026, which takes on outsized importance, because the Fed’s rationale for cutting is that labor market risks have risen. Yet, the SEP shows absolutely no changes to their unemployment rate projections. They expect the unemployment rate to hit 4.5% in 2025 (it’s 4.44% right now) and pull down to 4.4% in 2026 (the same projections as in September).
On the face of it, it’s puzzling to a lot of people that the Fed didn’t raise their unemployment rate projections. But there’re two reasons why, and it gets to the “bet” the Fed is making:
- First, they think they’ve lowered rates enough to stem a further increase in the unemployment rate (they’re also penciled in another cut in 2026).
- Second, higher economic growth in 2026 will boost the job market, and lower unemployment.
The Fed is essentially betting on productivity growth—with productivity growth, you can have higher economic growth, a stronger labor market, and lower inflation. And that allows for lower interest rates. It’s really as simple as that, though there’s nothing “simple” about this forecast (and it’s important to remember that it is just a forecast). In any case, this is a dovish outlook.
Markets currently expect the Fed to cut twice in 2026, versus the Fed’s median projection of one cut. This probably reflects those who favor two-plus cuts in 2026 (eight of 19 members), which is the most common view, and that a new Fed chair will likely come in with the view that rates need to be cut further.
Interestingly, market pricing diverges wildly from the Fed’s projections after 2027. While Fed members expect inflation to head back to target and policy rates to remain at their neutral rate of 3%, investors don’t buy it. Market pricing points to rate hikes from 2028 onward, presumably as inflation remains a problem (which the Fed ignores for the next couple of years).
In fact, by the end of the decade markets are pricing a policy rate of 4%, above where they are today. It appears that investors believe we’re in a relatively high inflationary environment right now. Even if inflation averages 2% over the next five years, it’s likely to be volatile. That’s our view as well. For 2026 specifically, our view is that we get re-acceleration and inflationary growth, rather than the Fed’s forecast of disinflationary growth (due to productivity gains).
The big takeaway though is this is a dovish tilt from the Fed on the back of a much more positive outlook for the economy. That combination makes “Don’t fight the Fed” even more applicable than usual right now, and we believe that’s positive for stocks.
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