By Martin Baccardax

The Federal Reserve has delivered an early holiday-season gift to markets with its quarter-point cut to interest rates. It also hinted at more easing over the coming months, even as officials nudged their growth and inflation forecasts modestly higher.

That likely creates a bullish backdrop for stocks into the final months of the year. Markets responded quickly in Thursday trading, as the S&P 500 was comfortably on pace for its 26th record high of 2025.

But the Fed's gross domestic product forecasts -- which see improving growth for the next three years -- also highlight a key risk to the market's impressive rally.

Jeffery Buchbinder, chief equity strategist at LPL Financial, notes that while stocks tend to perform well during the second year of a rate-cutting cycle, which the Fed has embarked on, they're also notably sensitive to weakness in the broader economy.

"Stocks fell during the 1980 -- 81 cycles (double-dip recession), the 2001 cycle (recession), and the 2007 cutting cycle (recession)," he said in a note published before the Fed's rate decision Wednesday.

"In other words, if stocks are going to rise over the next 12 months, it will likely require economic growth to continue," he added. "We think it will, supported by stable interest rates, cooling inflation, fiscal stimulus, continued robust artificial intelligence investment, productivity gains, and more rate cuts."

That said, the risks to the macroeconomic outlook are notable. Buchbinder cites labor market weakness, tariff uncertainty, and upward pressure on bond yields from record U.S. debt and deficits as potential stock market speed bumps.

"And with valuations elevated, it's possible that stocks produce lackluster returns even in a favorable economic environment," he added.

Stock market valuations are also a key concern for investors beyond the macroeconomic outlook.

Using the so-called CAPE method developed by Nobel-Prize-winning economist Robert Shiller -- which smooths out the effect of economic cycles on corporate profits -- the S&P 500 is trading at the most expensive level since the dot-com era.

That either means stocks are set for a pullback, or are fairly priced based on solid earnings forecast. So far, Wall Street seems to believe in the latter.

"For now, the bull market continues to earn the benefit of the doubt," said Keith Lerner, chief market strategist at Truist. However, he cautions that "corporate profits will be critical to monitor as we assess whether stocks can build on recent gains over the next year."

Bank of America analysts, led by Savita Subramanian, are confident that U.S. companies can deliver on earnings.

The team lifted its forecast for collective S&P 500 profits by $9, taking it to $271 a share, in a note published Wednesday. Their outlook for 2026 is pegged at $298 a share -- a bit below the consensus forecast of $304 a share. But their target still suggests a year-on-year advance of around 10% -- with more companies outside of the tech giants chipping in.

"After two years of a few companies doing the earnings work of many, 2026 forecasts indicate a broader distribution of forecasts," Subramanian wrote. "Tail risk is, in our view, is positive: outsized nominal GDP translating into sales growth, efficiency translating into profits growth, and real wage growth in skilled manufacturing amid a broader capex [capital expenditures] cycle."

Lori Calvasani, head of U.S. equity strategy at RBC Capital Markets, is also bullish on near-term earnings growth. She lifted her year-end price target for the S&P 500 by 100 points, to 6350, in a note earlier this week. That implies a 4.5% retreat over the next four months.

Her early outlook for 2026, which she says is a "compass, not a GPS," sees the S&P 500 rising 7.4% from current levels to 7100 points.

"The message we are trying to send with our analysis today is that the S&P 500 appears to be on a path higher over the next 12 months and into the second half of 2026," she said.

But, like LPL's Buchbinder, she notes that worrisome economic developments could throw the market a curveball.

"The biggest risks that we see to our 2026 view include a GDP or inflation backdrop that ends up being much hotter or cooler than we are currently baking into our models," she added.

Write to Martin Baccardax at martin.baccardax@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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September 18, 2025 13:54 ET (17:54 GMT)

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