With the S&P 500 trading above 4,000 and the CBOE Volatility Gauge, known as the “Vix” or Wall Street “fear gauge”, VIX,
having dropped to one of its lowest levels of the year, many Wall Street investors are starting to wonder if the lows have finally arrived for stocks, especially now that the Federal Reserve has signaled a slower pace of rate hikes. interest in the future.
But the fact remains: inflation is near a four-decade high, and most economists expect the US economy to slip into a recession next year.
The last six weeks have been good for US equities. The S&P 500 SPX index,
it has continued to rise after a stellar October for the stock and, as a result, has been trading above its 200-day moving average for a couple of weeks.
Furthermore, after leading the market higher since mid-October, the Dow Jones Industrial Average DJIA,
it is on the brink of exiting bear-market territory, having climbed more than 19% since its late-September low.
Some analysts worry that these recent successes could mean that US stocks have become overbought. Independent analyst Helen Meisler backed this up in a recent article she wrote for CMC Markets.
“My estimate is that the market is slightly overbought over the medium term, but could become completely overbought in early December,” Meisler said. And she’s hardly alone in anticipating that stocks could soon experience another pullback.
Morgan Stanley’s Mike Wilson, who has become one of Wall Street’s most-watched analysts after anticipating this year’s sell-off, said earlier this week that he expects the S&P 500 to bottom out around 3,000 during the first quarter of next year, resulting in a “fantastic” buying opportunity.
With so much uncertainty plaguing the outlook for stocks, corporate profits, the economy and inflation, among other factors, here are some things investors may want to analyze before deciding whether or not an investable floor in stocks has really arrived.
Easing corporate earnings expectations could hurt equities
Earlier this month, equity strategists at Goldman Sachs Group GS,
and Bank of America Merrill Lynch BAC,
warned that they expect corporate earnings growth to stagnate next year. While analysts and companies have cut their earnings guidance, many on Wall Street expect more cuts to come in the next year, as Wilson and others have said.
That could put more downward pressure on stocks as corporate earnings growth has slowed, but so far this year it’s still limping, thanks in large part to rising earnings for US oil and gas companies.
History suggests that stocks won’t bottom until the Fed cuts rates
A noteworthy chart produced by Bank of America analysts has made the rounds several times this year. It shows how over the past 70 years US stocks have tended not to bottom until the Fed cuts interest rates.
Typically, stocks don’t begin the long rally until the Fed has eased at least a few cuts, although the low point of the COVID-19-inspired selloff in March 2020 coincided almost exactly with the Fed’s decision to cut rates . to zero and unleash a massive monetary stimulus.
Furthermore, history is no guarantee of future performance, as market strategists like to say.
The Fed’s key policy rate could rise more than investors expect
Federal funds futures, which traders use to speculate on the future path of the federal funds rate, currently sees interest rates peak in the middle of next year, with the first cut most likely coming in the fourth quarter, according to the report. CME’s FedWatch tool.
However, with inflation still well above the Fed’s 2% target, it’s possible – perhaps even likely – that the central bank will have to keep interest rates higher for longer, inflicting more pain on equities, he said. said Mohannad Aama, a portfolio manager at Beam Capital.
“Everyone expects a cut in the second half of 2023,” Aama told MarketWatch. “However, ‘higher for longer’ will hold true for the entire duration of 2023, which most people haven’t modeled,” she said.
Higher interest rates longer would be particularly bad news for growth stocks and the Nasdaq Composite COMP,
which outperformed during the era of record-low interest rates, market strategists say.
But if inflation doesn’t retreat quickly, the Fed may have no choice but to persevere, as several senior Fed officials, including Chairman Jerome Powell, have said in their public comments. While markets celebrated slightly weaker-than-expected inflation readings for October, Aama believes wage growth has not yet peaked, which could keep pressure on prices, among other factors.
Earlier this month, a team of Bank of America analysts shared a model with clients that showed inflation may not substantially dissipate until 2024. According to the most recent rate forecast “dot chart” interest rates, senior Fed policy makers expect rates to peak next year.
But the Fed’s own predictions are rarely successful. This has been especially true in recent years. For example, the Fed backed down the last time it attempted to materially raise interest rates after President Donald Trump lashed out at the central bank and ructions rocked the repo market. Eventually, the advent of the COVID-19 pandemic inspired the central bank to cut rates down to the zero limit.
The bond market is still heralding a recession ahead
Hopes that the US economy can avoid a punishing recession have certainly helped boost stocks, market analysts said, but in the bond market, an increasingly inverted Treasury yield curve is sending just the opposite message.
The yield on the 2-year Treasury note TMUBMUSD02Y,
on Friday it traded more than 75 basis points higher than the 10-year note TMUBMUSD10Y,
at its most reversed level in more than 40 years.
At this point, both the 2s/10s yield curve and the 3m/10s yield curve have essentially inverted. Inverted yield curves are seen as reliable indicators of recession, with historical data showing that a 3m/10s reversal is even more effective at predicting impending downturns than a 2s/10s reversal.
With the markets sending mixed messages, market strategists said investors should pay more attention to the bond market.
“It’s not a perfect indicator, but when stock and bond markets differ, I tend to believe the bond market,” said Steve Sosnick, chief strategist at Interactive Brokers.
Ukraine remains a wild card
Indeed, it is possible that a quick resolution to the war in Ukraine could boost global inventories, as the conflict has cut off the flow of critical commodities including crude oil, natural gas and wheat, helping to fuel inflation in Worldwide.
But some have also speculated that the continued success of the Ukrainians could provoke an escalation by Russia, which could be very, very bad for markets, not to mention humanity. As Marko Papic of Clocktower Group said: “Actually I think the biggest risk to the market is that Ukraine continues to demonstrate to the world how capable it is. Further successes by Ukraine could therefore provoke an unconventional reaction from Russia. This would be the greatest risk [for U.S. stocks]“said Papic in comments emailed to MarketWatch.