“Don't fight the Fed” is a fundamental financial market motto that most investors absorb with their baby food.
The maxim makes sense: the Federal Reserve acts not only as the central bank of the United States but also as an effective agency for setting interest rates for the rest of the world, given the exceptionalism of the domestic economy and the power and ubiquity of the dollar in the world. global trade.
And the arithmetic of financial markets is pretty easy to understand, at the basic level: higher interest rates = lower asset prices.
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So why are stocks still breaking records, at home and abroad, when Federal Reserve officials are everywhere telling anyone who will listen that they are in no rush to cut rates this spring and that They may even decide to wait until well into the summer to reverse some of the most aggressive policy adjustments in a generation?
It's a question that has dogged markets this year and has largely undermined the narrative surrounding the S&P 500's march past the 5,000 level this week. That move cemented the benchmark index's bull run from last October's lows and now values blue-chip U.S. companies at nearly $42 trillion.
First, many investors are concerned about the narrow breadth of this year's rally, which LPL Financial chief technical strategist Adam Turnquist said has been driven by just a few stocks.
“Amazon, Meta, Microsoft and Nvidia have done most of the heavy lifting,” contributing nearly 75% of the S&P 500's total performance this year, he said. “That's more than double the contributions of the top four stocks during this time last year.”
High valuation of the S&P 500 despite high rates
Oscar Wilde once wrote that a cynic is someone “who knows the price of everything and the value of nothing.”
That's an apt phrase to remember when the S&P's 500-point level (its “price”) rises above 5,000 because valuations are also high. The benchmark's forward price-earnings multiple rose to 20.4 times this week, the highest in at least two years and well above the historical average of about 15.7 times.
“Valuations remain a hot topic, with the S&P 500's price-to-earnings ratio hovering around the 92nd percentile of its historical valuation, surprising some investors,” according to a recent note from market research firm Toggle ai.
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Saxo Bank strategists note that while stocks still show better long-term value prospects than government bonds, the high forward P/E multiples mean that “any change in (market) sentiment could be quite large and reset shares by up to 10%”. “
And while the Fed may not be trying to induce a stock market pullback, its recent messaging suggests it is at least a little concerned that financial conditions, which drive credit growth and economic activity, are likely are too easy.
Federal Reserve members say patience is a virtue
“The unexpected strength in recent GDP and labor market data exemplifies the current resilience of demand and highlights that the anticipated slowdown in activity may take some time,” Boston Federal Reserve President Susan said last week. Collins, during a speech before the Economic Club of New York. .
“I think it's smart that we take our time,” he added.
That view was echoed by Richmond Fed President Thomas Barkin, who also told the Economic Club of New York that “given robust demand and a historically strong labor market, we have time to build that confidence before we begin the process.” to lower rates”.
Even Philadelphia Federal Reserve President Patrick Harker, who noted “real progress” in slowing inflation over the past six months, highlighted the need for more downward pressures on prices, a balanced labor market and a resilient consumer spending to “maintain the soft landing we continue to have.” optimistic to achieve.”
More economy:
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However, investors still haven't fully gotten that message, even as they have withdrawn their earlier bets on an interest rate cut by the Federal Reserve in March.
CME Group's FedWatch tool suggests traders are pricing in a 52.5% chance that the Federal Reserve will cut its benchmark borrowing rate by 0.25 percentage points in May. That rate is currently between 5.25% and 5.5%.
New points could change your mind
Later bets suggest Wall Street is looking at at least four cuts this year, possibly five, while official Federal Reserve projections suggest a maximum of three.
Furthermore, those projections could change dramatically when the Federal Reserve releases its latest version of so-called Dot Plots rate projections next month, as officials will have two more inflation readings, as well as the February jobs report, to evaluate their new estimates. forecasts.
That could be why the world's biggest fund managers are pulling money out of stocks ahead of next week's inflation data, which is expected before the market opens on Tuesday.
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Bank of America's weekly Flow Show report noted an outflow of $15.6 billion from U.S. equity funds last week, the largest since September. Money market funds now hold record assets of more than $6 trillion.
“I'm concerned that this rally is losing steam,” said Jay Woods, chief global strategist at Freedom Capital Markets, pointing to issues with the market's lack of breadth.
“A pause or a setback is coming,” he added. “But a major setback? Probably not.”
5,000 facts. Once again in the gap
LPL Financial's Turnquist notes that stocks, having broken through a round-number benchmark like the 5,000 mark, tend to extend gains over the long term.
“Of the last nine, the index recorded an average 12-month return of 10.4% after passing each milestone, with 78% of occurrences producing positive results,” he said.
But he added: “There have only been two milestones that were not subsequently crossed after being surpassed.” This suggests the possibility of short-term weakness.
Federal Reserve Chair Jerome Powell, for his part, is determined to limit the scope of interest rate decisions to economic data, not market performance.
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And he has stressed time and again that he is in no rush to make changes.
“If the economy were to weaken, then we could reduce rates sooner and perhaps faster,” he said last week on CBS' “60 Minutes.” “If the economy (or inflation) were more persistent, that might require us to cut rates later and perhaps more slowly.”
Now that the S&P 500 has pocketed the 5,000 mark, investors will be watching to see exactly how that plays out.
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