Sentiment is driven by price, and with the Nasdaq and S&P 500 both back in bull market territory, investors appear to be feeling better than they were six months ago. Before we discuss what to expect from here, let’s explain three potential drivers of this newfound optimism.
First, the Federal Reserve appears to be out of its self-inflicted “crisis mode.” Rewind the clock to early 2021, and the Fed had increased the money supply by over 40% in less than two years – a pace unseen since World War II. They then ignored the subsequent inflation for too long, only to panic big time and raise interest rates at ten consecutive meetings.
They did more than just hike rates. To show the world they were serious, the Fed took every opportunity to pound its chest publicly and use language that no central banker would normally utter in public. They wanted to see the stock market crash.
But since February, the Fed has continually softened its tone while slowing their rate hikes to a full stop earlier this month. That’s because inflation is half where it was a year ago, and although they may feel that there’s still work to do to get it lower, they also don’t seem willing to crash the economy to get there.
Second, a “soft landing” is looking more probable. Back in January, we suggested that the odds that the Fed would tame inflation without causing a recession was difficult but not impossible. Despite this highly-contrarian view at the time, we positioned most of our diversified investment strategies accordingly.
Today, employment trends remain mostly strong despite falling and tighter access to money. There are still 1.8 jobs available for every person looking, and unemployment hasn’t been this low since Woodstock1. Wage growth recently ticked higher than inflation, meaning Americans are building real wealth again2.
This may be why consumer spending has also persevered. Recent retail sales data suggest that although spending is off its record high (fueled by free money from Uncle Sam), the trend continues to be above pre-lockdown levels.
Third, the tone on Wall Street is changing. Economists and strategists are notoriously late to the party, but when they arrive, it often signals a higher likelihood that the recovery has legs (mainly attributed to diminished career and reputation risk). Many of those that said a recession was a near certainty six months ago have either delayed or dropped this forecast4.
The reaction to news flow is also signaling a potential sentiment shift. Until recently, positive economic data caused the stock market to sell off because it suggested the Fed may raise rates higher. But over the past few weeks, good news no longer appears to be bad news for stocks. When that happens, it tends to be a bullish sign.
Lastly, expectations for corporate earnings are improving. Companies have done a pretty good job preparing for an economic downturn, which has helped to protect operating margins and free cash flow. This is critically important to the stock market's future because earnings are the key driver of long-term stock prices. Add it all up, and there are good reasons why the two charts below suggest that the bulls are back in town5.
The bottom line
Now what? Can we all breathe a collective sigh of relief, kick back, and relax, knowing that stocks are back on track? If the bear market is over, won’t we return to the glory days when interest rates were close to zero, and there was no alternative to stocks?
I’m not so sure. In this business, being too much of a Pollyanna can often be just as unprofitable as an eternal Cassandra. Blinding optimism ignores danger, and there’s always risk lurking out there. Forecasting tends to be a fool’s errand, but some considerations for the second half of the year give us pause.
First, expect a few volatility spikes and maybe even a “correction,” defined as a pullback of more than 10%. These are features of bull markets, not bugs, and every bull market experiences corrections. But that doesn’t mean investors will see it that way. I’d wager that many are still snake-bit from last year. Sentiment may be positive, but it’s also fragile right now.
Second, unlike the last bull market, there is an alternative to stocks today. In fact, there are several, like corporate bonds and Treasuries. Many of these yielded less than inflation in the last bull market, but with interest rates at these levels, they are most certainly an alternative for investors who don’t want to overweight stocks.
Third, just as the risk of a recession six months ago was not 100%, today's risk is not 0%. The economy isn’t firing on all cylinders, and the Fed has a poor track record of avoiding recessions after raising interest rates like this.
Throwing caution to the wind and backing up the truck simply because a few investor surveys suggest rising optimism doesn’t seem like a prudent approach. Therefore, just as we positioned for the possibility of a soft landing six months ago, we’re doing the same for a potential recession later this year or next. Moves like these are what keep our dynamic approach to investing diversified and disciplined.
The bottom line is that when it comes to investing in stocks, time favors the optimist. We welcome this sentiment shift with open arms, but we’re also careful not to get too cozy either.
3 The Federal Reserve.
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.