Wall Street got the rate cut it wanted. Can the optimism last?

By John Towfighi, CNN

New York (CNN) — The stock market is shrugging off worries about a weakening labor market and stubborn inflation, instead embracing a much-anticipated interest rate cut.

That optimism still has room to run, analysts say, but stocks could hit a wall if worries about an economic slowdown and still-high prices begin to weigh on consumer spending or businesses’ earnings.

The Dow, S&P 500 and Nasdaq each hit back-to-back record highs last week after the Federal Reserve delivered its first rate cut since December.

The S&P 500 is up 13% this year, rising through tariff uncertainty and concerns about the Trump administration encroaching on the Federal Reserve’s independence.

Investors see more room for stocks to run despite the economy showing signs of frailty. While the Fed balances an increasingly complicated dynamic, investors are cheering the prospect of a rate-cutting cycle – even as experts warn the market is increasingly divorced from economic reality.

Concerns may be mounting about the emergence of a “K-shaped economy,” but the stock market keeps rising as corporate America’s profits keep beating Wall Street’s expectations.

About 81% of companies in the S&P 500 posted second quarter earnings-per-share results that beat Wall Street’s expectations, according to FactSet data.

Until there is evidence of a real hit to corporate profits, stocks will continue to grind higher, said Larry White, professor of economics at NYU Stern. The market is “downplaying the risk” about the fractures in the economy, he added.

“Everybody I know is concerned, but we’re not the markets,” White said. “And the markets are just clearly optimistic.”

Fed rate cut fuels record highs

Interest rate cuts can lower savings rates and borrowing costs, encouraging spending and investing, spurring business activity and creating a sustained tailwind for stocks.

The Fed’s dot plot — an indication of where committee members think futures rates will be — outlined expectations for two more rate cuts this year, which is in line with Wall Street’s expectations.

“The stock market bonanza shows no signs of fatigue after (the) Fed decision was accompanied by predictions of … more cuts by Christmas,” José Torres, senior economist at Interactive Brokers, said in a Thursday note.

The Russell 2000, an index of smaller companies that are more sensitive to interest rates, closed at its first record high since 2021 on Thursday. The Russell has soared 40% since its low point in April, entering a new bull market as small businesses embrace optimism about lower rates.

Seema Shah, chief global strategist at Principal Asset Management, said the outlook remains positive for stocks.

“This is a decent backdrop for equities,” Shah said. “It’s not boom times, but ultimately, what we heard from the Fed is, ‘Fine, the economy is slowing. There’s a couple of labor market concerns growing,’ but they’re not overly worried.”

“There’s some comfort and confidence that they can arrest the (labor market) slowdown before it gets away from them,” Shah added. “And the Fed cuts give a little bit of extra juice to the (stock) market.”

Since 1980, when the Fed has cut rates while the S&P 500 is trading near all-time highs, the index has risen across the next 12 months about 90% of the time, according to research from Keith Lerner, co-chief investment officer at Truist Advisory Services.

“Corporate profits continue to be the north star for the market and will be critical to monitor,” Lerner said. “For now, the bull market continues to earn the benefit of the doubt.”

Priced to perfection

While stocks grind higher, uncertainty always lingers.

Federal Reserve Chair Jerome Powell on Wednesday upheld the image of a united and data-dependent Fed, which helped give a boost of confidence to investors. Yet Powell highlighted concerns about sticky inflation and said there is “no risk-free path” ahead for the central bank.

Bank of America on Wednesday upgraded its forecast for the S&P 500’s profitability growth this year. Still, strategists cited risks related to the impact of tariffs on inflation and the potential for consumer spending to slow down if the labor market deteriorates further.

Companies have navigated Trump’s tariffs “without significant margin degradation so far, but the full impact may be yet to come,” Savita Subramanian, equity strategist at Bank of America, said in a note.

And while there is a tremendous amount of uncertainty about the path forward for the economy, stocks are trading at historically expensive valuations. In Bank of America’s latest survey of global fund managers, a record 58% of respondents said global stock markets are “overvalued.”

“There is a disconnect between the market and the economy,” said David Kelly, chief global strategist at JPMorgan Asset Management.

“We’re certainly overdue for a bit of a pullback. I think the rally could continue until the economy receives some genuine shock, but people need to be wary about valuations,” Kelly said. “We can’t time when this huge bull market will turn, but I do think for investors, it’s long past time to think about rebalancing portfolios.”

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