Just to fill everyone in on the temperature of investors, the only thing I have heard from everyone that is calling in is when we should sell. Not one person has said that they are prepared to invest more capital. Usually the crowd is wrong, maybe not this time, but usually the crowd is wrong. The stock market has refused to provide any sort of lower-risk entry point to add more exposure. If one wants to buy, he or she has been forced to do so while the general market is stretched. According to Bespoke Investment Group, this turnaround from October 27th has been the fastest turnaround EVER from 52-week lows to 52-week highs for the Russell 2000 Index (this is the index of small companies). This upside explosion is truly unique in magnitude and time.
The last week two weeks of surge has been attributed to last week’s Fed meeting right after my report two Wednesdays ago (December 13th). With their policy announcement, the Fed really just confirmed the narrative that the market had already created —that rate hikes are done, and rate cuts are likely sometime next year. Usually, when an event is clearly signaled such as this, the market will buy the rumor but then sell the news. In this case, however, the market bought the rumor and then turned right around and bought the news! To repeat, we are dealing with an exceptional period here in defiance of history. I believe that the difference “this time” is that first, so much cash is on the sidelines- STILL and there has been massive liquidation of stocks so far this year. When the Fed does a complete directional policy change like this, there is short covering and outright buying- particularly into year-end as money managers don’t want to be left flat footed and not participating.
The sharp about-face from the Fed has been discussed ad nauseam over the past two weeks. Just around six weeks ago, Jerome Powell told reporters that the Fed wasn’t even thinking about cuts, but at last week’s meeting they signaled a 75basis point reduction in 2024 is their new expectation. So, what caused this clear quick shift in policy?
What caused this clear quick shift in policy?
I have seen all sorts of reasons provided, from the sensible to the conspiratorial. In the latter camp, some feel the Fed pivot is a coordinated effort to keep Donald Trump out of the White House, with the timing coming right as the former president has gained in polls vs Joe Biden heading into the election year. If there’s any truth to this, we aren’t likely to ever know what went on behind closed doors, so I don’t see much point in debating it.
In the sensible camp is the simple fact that the Fed embarked on their hiking cycle in order to combat inflation and, at least based on the way they measure it, the rate of inflation has come down even if prices have not (consumers may not be as enthused as the Fed). And with the Conference Board’s Index of Leading Economic Indicators now falling for 19 consecutive months, there is little reason to remain so restrictive and risk forcing the slowdown to accelerate to a dangerous point of no return. This is the impossible, perfect result to shoot for. Since every time the internal and global political issues are different, it really requires hard work, hand wringing and a leap of faith to time this absolutely perfectly. There are also questions regarding how long the government can continue to service 5%+ rates with the debt load already so large and growing each year.
On the other hand, the more cynical may say that the Fed is simply at the mercy of the market —that their policy is more reactive than proactive. Since the previous meeting in late October/early November when Powell stated they were “not thinking about cuts,” the market showed that it was already thinking about cuts as the interest rates topped out before Powell’s comments, and so on December 13th the Fed simply responded to that newly-formed expectation. Like Santa Claus, you either believe or you don’t. Yet, this does appear to be another example of this dynamic playing out. The market gave its “permission” for cuts next year, and the Fed responded with acquiescence to give the market what it wants.
That said, it should be remembered that the Fed’s policy will continue to be restrictive next year if the current expectations hold true. According to what we learned from Powell’s comments, the Fed projects inflation to continue to fall next year to 2.8% and will respond by cutting rates by 75-basis points. That means their target Fed Funds rate would come down from its current 5.25-5.50% to 4.50-4.75%, still almost 200 bps above the expected inflation rate. Again, that remains restrictive so the market may be getting a little ahead of itself in responding as if rates are going straight back to 0%. Moreover, if the economy stays resilient, then lowering rates risks kickstarting inflation once again, particularly given existing upward pressures on wages. Regardless, inflation is likely to remain above the frequently cited 2% target rate for the foreseeable future barring a bad recession, though considering it spent much of the past decade consistently below it, such overshooting on the upside could just be a normal corrective response. Of course, these expectations and projections are always subject to change depending on the new data that comes in and shifts in market expectations.
Speaking of the S&P 500, it has shown little interest in either fundamental or technical analysis lately. Neither valuations nor resistance have mattered since the October low and until that changes it’s hard to really provide any rational analysis for what “it may do” in the near term. Based on historical probabilities, we should see stocks pull back from these extreme levels but that has been the case for much of the past few weeks! As noted above, this “overboughtness” has produced almost nothing on the downside, at least not in the S&P 500. I often say that the markets can do anything, and this is a perfect example of that. So, there is nothing to say that the market cannot continue to remain “irrational” indefinitely.
I still believe the strength we’ve witnessed lately supports that the market should at least ultimately carry into that 4800-5000 region. In the last two weeks I have shared the work of Ari Wald that shows the breadth of participants increasing and what this has meant in the in past for the immediate future expectations within the markets. And as I noted last week, the potential “cup and handle” pattern that has formed in the S&P has a minimum price projection up around 5700 (please know that I don’t mean that the market is at all expected to go straight there), so there is upside potential even beyond 4800-5000.
Historically, the kind of “breadth thrust” we saw last month has a very strong track record of producing higher prices. There are different definitions of what constitutes a “thrust” but perhaps the most popular is the Zweig Breadth Thrust popularized by the late Marty Zweig. Since 1945, the previous 17 instances of such a surge in breadth led to higher prices 100% of the time over the next 6 and 12 months. History would therefore suggest that we should look higher, though without being blind to potential warning signs should they develop.
So, in short, there is little reason to aggressively fade this strength until we see some more danger signs emerge, though some sort of pullback could still begin at any time. As long as such retracements are corrective in nature and remain generally shallow, these can be viewed as opportunities to add or add back risk. As the S&P 500 gets near and into that 4800-5000 region I am looking for “new merchandise” that hasn’t quite participated, but for the most part will continue a positive bias until the markets appear tired and start to dictate otherwise.
In last week’s report I exemplified the “three steps down” that the market experienced from July till late October. Below, is the “three steps up” that we have just experienced:
The caution that I have is that virtually ALL the indexes are right back to their high points of late 2021. This would be a perfectly logical place for the markets to take a rest and gain a little more steam before powering higher. If this should happen, we will be inclined to be less positive and act accordingly.
In closing, the Fed was remaining tough on inflation, ready to hike if needed, but also paused to make sure the hikes were working. Hence, they did nothing for the last few meetings. Then the switch flipped, and the Fed was discussing rate cuts and not going too far toward and causing economic issues. Something or someone (economic data or the executive branch) changed the conditions and Powell changed. Of course, reigniting inflation is a danger that they clearly remember as this occurred in 1974 where the inflation came roaring back and they were forced to hit the tightening cycle again. We don’t know what will happen this time, but I BELIEVE that until we burn off the ether of all this free cash sloshing around, the true measure of the economy and inflationary consumer prices will be tough to measure accurately, and we must remain vigilant on the path of earnings of the market participants.
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The Standard & Poor's 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
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