Stock Market Investors Just Got Bad News From the Federal Reserve. History Says This Will Happen Next.

The U.S. stock market is having a decent year despite economic uncertainty created by the Iran conflict. The broad-based S&P 500 (SNPINDEX:^GSPC) has advanced 11%, the technology-heavy Nasdaq Composite (NASDAQINDEX:^IXIC) has added 14%, and the blue chip Dow Jones Industrial Average (DJINDICES:^DJI) has added 7%.

However, investors got bad news from the Federal Reserve last week. Policymakers raised interest rates for the first time in more than three years. Historically, new rate-hike cycles have often coincided with stock market corrections. Read on to learn more.

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Wall Street just got bad news from the Federal Reserve

Inflation has now exceeded the Federal Reserve's 2% target for more than five years. Fed Chairman Kevin Warsh has, on multiple occasions, vowed to restore price stability. And the Federal Open Market Committee (FOMC) took its first step in that direction last week when its 12 members voted unanimously to raise the target range on the federal funds rate by a quarter percentage point.

The federal funds rate is a benchmark that influences other interest rates throughout the economy, including auto loans and credit cards. A higher federal funds rate suppresses economic growth and slows inflation by raising borrowing costs and tightening financial conditions, and those changes are generally bad news for the stock market.

There are two reasons for that: First, higher borrowing costs stifle business and consumer spending, thereby slowing corporate earnings growth. Stocks are generally valued based on earnings, so prices tend to fall when forward earnings estimates drop. Second, higher interest rates make bonds look more attractive, which can pull money away from equities.

Indeed, the 10-year Treasury bond yielded more than 5% when the market closed on Sept. 16, the highest payout since July 2007. What happened last time? The S&P 500 tumbled into a bear market, declining more than 20% during the subsequent year.

The Federal Reserve had more bad news for investors: 16 of 18 meeting participants expect another quarter-point rate hike in the remaining months of 2026, which would bring the target range on the federal funds rate to 4% to 4.25%. And the vast majority of participants expect rates to stay at that level through 2027.

Historically, new rate-hike cycles have often led to stock market corrections

New tightening cycles are relatively rare. In fact, the Federal Reserve has only initiated five rate-hike cycles in the last 30 years. Following the first hike in each cycle, the S&P 500, Nasdaq Composite, and Dow Jones often recorded double-digit losses within three months, as shown in the chart below.

Data source: Federal Reserve, YCharts. The chart shows the maximum drop in the S&P 500, Nasdaq Composite, and Dow Jones Industrial Average during the three-month period following the first interest rate hike in a tightening cycle.

As shown above, the major U.S. stock market indexes have frequently entered stock market correction territory within three months of the first rate hike in a new tightening cycle.

Of course, past performance is never a guarantee of future results. S&P 500 companies are forecast to report 31% earnings growth this year -- a pace that, excluding post-recession recoveries, has not been seen in over three decades. The artificial intelligence infrastructure build-out is a key driver of that growth, and the stock market could keep moving higher as long as investor enthusiasm for the AI boom remains strong.

Importantly, if the major stock market indexes do sink into correction territory, history says investors should treat the dip as a buying opportunity. The stock market has always recouped its losses, meaning every past drawdown has been a good opportunity to invest, and there is no reason to expect a different outcome in the future.

Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.