With the S&P 500 holding above 4,000 and the CBOE volatility gauge, known as Wall Street’s “Vix” or “fear gauge,” VIX,
having fallen to one of its lowest levels of the year, many Wall Street investors are starting to wonder if the lows are finally being reached for stocks – especially now that the Federal Reserve has signaled a slower pace of rising interest rates in the future.
But the fact remains: inflation remains near four-decade highs and most economists expect the US economy to slide into recession next year.
The past six weeks have been positive for US equities. The S&P 500 SPX,
continued to climb after a bumper October for stocks and as a result has been trading above its 200-day moving average for a few weeks now.
Additionally, after leading the market higher since mid-October, the Dow Jones Industrial Average DJIA,
is about to break out of bear market territory, having risen more than 19% from its late-September low.
Some analysts worry that these recent successes mean US stocks have become overbought. Independent analyst Helen Meisler made the point in a recent article she wrote for CMC Markets.
“My estimate is that the market is slightly overbought in the medium term, but could become completely overbought in early December,” Meisler said. And she’s not alone in anticipating that stocks could soon see another pullback.
Morgan Stanley’s Mike Wilson, who has become one of Wall Street’s most-watched analysts after anticipating this year’s sharp selloff, said earlier this week that he expects the S&P 500 to bottom out. lows of around 3,000 in the first quarter of next year, which will lead to a “tremendous” buying opportunity.
With so much uncertainty hanging over the outlook for equities, corporate earnings, the economy, and inflation, among other factors, here are a few things investors might want to consider before deciding whether an investable bottom in equities is really happened or not.
Weaker expectations for corporate earnings could hurt stocks
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 earnings forecasts, many on Wall Street expect further cuts as we approach next year, as Wilson and others have said.
That could put more downward pressure on stocks as corporate earnings growth has slowed, but continues to slow so far this year, thanks in large part to rising profits at U.S. oil and gas companies.
History suggests stocks won’t bottom until the Fed cuts rates
A notable chart produced by analysts at Bank of America has made the rounds several times this year. It shows how, over the past 70 years, US stocks have tended to bottom out only after the Fed cut interest rates.
Stocks typically don’t start the long upside job until after the Fed has pared at least some cuts, although in March 2020 the nadir of the COVID-19-inspired sell-off coincided almost exactly. with the Fed’s decision to cut rates. to zero and trigger a massive monetary stimulus.
Again, history is no guarantee of future performance, as market strategists like to say.
The Fed’s benchmark rate could rise more than investors expected
Federal funds futures, which traders use to speculate on the way forward for the federal funds rate, currently see interest rates peak in the middle of next year, with the first drop most likely coming in the middle of next year. fourth quarter, according to the CME’s FedWatch tool. .
However, with inflation still well above the Fed’s 2% target, it’s possible — maybe even likely — that the central bank will have to keep interest rates higher for longer, inflicting more pain on investors. stocks, said Mohannad Aama, portfolio manager at Beam Capital. .
“Everyone is expecting a reduction in the second half of 2023,” Aama told MarketWatch. “However, ‘higher for longer’ will hold for the full span of 2023, which most people haven’t modeled,” he said.
Higher interest rates for longer would be especially bad for growth stocks and the Nasdaq Composite COMP,
which outperformed during the era of lowest interest rates, according to market strategists.
But if inflation doesn’t come down 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. As markets celebrated slightly weaker-than-expected October inflation readings, Aama believes wage growth has yet to peak, which could keep pressure on prices, among other factors. .
Earlier this month, a team of analysts from Bank of America shared with clients a model that showed inflation may not dissipate substantially until 2024. It will peak next year.
But the Fed’s own forecasts rarely materialize. This has been especially true in recent years. For example, the Fed backed off the last time it attempted to raise interest rates significantly after President Donald Trump attacked the central bank and turmoil rocked the repo market. Ultimately, the advent of the COVID-19 pandemic prompted the central bank to cut rates to zero.
The bond market still signals a coming recession
Hopes that the U.S. economy could avoid a punishing recession certainly helped lift stocks, market analysts said, but in the bond market, an increasingly inverted Treasury yield curve sends the exact opposite message.
The yield of the 2-year Treasury note TMUBMUSD02Y,
Friday was trading more than 75 basis points higher than the TMUBMUSD10Y 10-year note,
around its most inverted level in over 40 years.
At this point, the 2s/10s yield curve and the 3m/10s yield curve have inverted significantly. Inverted yield curves are considered reliable indicators of recession, with historical data showing that a 3m/10s inversion is even better at predicting impending downturns than the 2s/10s inversion.
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
Certainly, a quick resolution to the war in Ukraine may push global stocks higher, as the conflict has disrupted the flow of critical raw materials, including crude oil, natural gas and wheat, helping to fuel the inflation in the world.
But some have also imagined how continued success from the Ukrainians could cause an escalation from Russia, which could be very, very bad for markets, not to mention humanity. As Marko Papic of the Clocktower Group put it: “I actually think the biggest risk to the market is if Ukraine continues to show the world how capable it is. Further successes from Ukraine could then provoke an unconventional reaction from Russia. That would be the biggest risk [for U.S. stocks]”Papic said in comments emailed to MarketWatch.
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