Near the end of a year, the collective Wall Street outlook often tends to cluster around “more of the same,” extrapolating the most recent market themes as the key ones for the coming year. At this time in 2022 — as a nasty December sell-off had undone half the rebound rally of the October bear-market low and economists as a group saw a recession in 2023 as a lock — the consensus was that the lows would at least be retested and the Federal Reserve would have to wrestle the economy to the ground. Flash to now, with the S & P 500 closing 2023 with nine straight up weeks, a 24% annual gain and a fourth-quarter rally that seized upon “disinflationary economic resilience” data and a Fed turn toward possible rate cuts to broaden out aggressively even to the smallest and most mistreated stocks. This has turned an apparent majority of investors into tentative believers in a soft landing, with many voices embracing the average stock and small-caps over the defensive quality mega-caps that led for most of 2023, with a sprinkling of warnings that market-based expectations of deep Fed rate cuts are premature and the indexes a bit ahead of themselves. It’s hard to quibble vigorously with the broad outlines of this outlook for the immediate stretch of road ahead. Inflation falling faster than the Fed had anticipated has meant good news on the economy can be good news for stocks. Timely labor-market indicators show no real give in labor demand or wage growth, even as consumer fatigue is emerging in some pockets. But it’s worth scrutinizing a few popular talking points. Investors too bullish? Is excessive bullish sentiment a problem yet? The indexes have been statistically overbought for weeks and we’ve seen an understandable upwelling of investor optimism in surveys and fund flows. Last week saw the biggest net flow into U.S. equity funds in six months, and the National Association of Active Investment Managers’ weekly equity exposure gauge shows this group leveraged long stocks for the first time since the summertime market peak in late July. Yet in up-trending markets this sort of behavior is unremarkable and not an automatic cause to assume the market must decline. Jason Goepfert of Sentiment Trader says buying the S & P once this gauge crosses above 100% exposure and selling on either a 5% gain or 5% loss was profitable 12 of the last 15 times since 2007. Citi’s slower-moving Levkovich Index sentiment composite measure is rising but not yet “euphoric,” reaching a level that implies a 71% chance of positive 12-month forward returns for the S & P 500, slightly lower than the 77% overall average probability. Jeff deGraaf of Renaissance Macro says the momentum and breadth displayed by the rally since October outweighs concerns about stretched sentiment for now. He allows that a first-quarter setback appears fairly likely but the trend places him in buy-the-dips mode, with anticipated downside in any correction probably reaching only to about 4600 on the S & P, down 3-4%. .SPX YTD mountain S & P 500, YTD As for the “too far, too fast” argument, it’s worth recalling that all the S & P 500 has done is nearly complete an almost-symmetrical two-year round trip. It peaked two years ago this coming Wednesday at 4797, a half-percent up from here. Since that time, U.S. nominal GDP is up some 12%, earnings up a similar amount, and we absorbed a complete Fed tightening cycle along the way. Ned Davis Research U.S. strategist Ed Clissold looked back at prior times the S & P 500 has gone more than a year without making a record high. Once the index got back to the former peak, it went on to gains over the ensuing year 13 or 14 times, for a median gain above 13%. Likewise, Bespoke Investment Group screened for prior years that ended, as 2023 did, when the S & P 500 stayed overbought, in statistical terms, for four or more weeks. It’s happened 10 times since 1950, and subsequent index performance was better than average over the following month, quarter and six months, though with a somewhat lower chance of gains over the next year. Bespoke says this shows, “as strong as the rally to close out 2023 has been, there is no historical evidence to suggest that it is borrowing from the future.” Fed vs. the market The above indicators seem to place the “Don’t fight the tape” logic on the side of the bulls for now. But what about the “Don’t fight the Fed” maxim? Clearly Fed Chair Jerome Powell meant to convey the next likely move is a rate cut at some point in 2024, and he crucially said it would be justified even if the economy held up well. Assuming inflation keeps leaking lower, current short-term rates above 5% will grow more restrictive, undesirably, and fine-tuning “peacetime” rate cuts would make sense. The Fed’s consensus projection was for perhaps 0.75 percentage points of cuts in 2024. Yet the Fed funds futures market is now priced for 1.25 percentage points, leading many wags to assume both that this represents an embedded expectation among investors and that the market “needs” such easing. The hackneyed “Fed vs. the market” framework has again been trotted out. The thing is, such an apparent split was also present at the start of 2023, and what I wrote about it then still applies: “Much has been said, understandably, about the apparent gulf between the market’s implied forecast (for the Fed to be cutting rates by the end of the year) and the Fed’s (preaching “higher rates for longer”). “Yet the market must price in a range of probabilities, which include the chance that inflation crashes quickly or an economic accident forces the Fed to reverse itself. Fed officials are simply conveying their current intentions, overlaid with the messaging they think will best keep markets in line with their goals.” This year, those rate cuts that were “priced in” as of January came out of the futures market and the stock market still worked its way higher as the economy outperformed expectations. In that same Jan. 14, 2023, column , I dangled a potential bullish case for stocks that was hard to trust at the time but more or less has played out. Given that conventional wisdom for most of the year held that the market was dangerously narrow in its leadership all year, it’s no surprise that many have grabbed on to the “many over the few” trade, speaking in favor of equal-weight S & P 500, financials and smaller stocks for continued catch-up. No strenuous argument against this, given good relative valuations and prospects that the economy can hang tough with yields well off their highs. And we’re approaching the third anniversary of the peak of the speculative profitless tech cohort of stocks, most of which look to have been basing for many months and now starting to break higher. Perhaps the buyers of such names have been “wrong enough for long enough” for their luck to turn? Yet maybe the better call is that the market won’t be such an either/or proposition looking ahead, favoring either the Big Seven or the tiniest. The defensive, AI-propelled, quality mega-cap Magnificent Seven held the market together through much macro flux this year and a ramp in bond yields. Yet not a single one of the Seven trades at a higher valuation now than it did at its late-2021 peak multiple, thanks to strong profit growth. Cash on the sidelines One bullish argument that seems misplaced is that “cash on the sidelines’ will wash over the equity market after the public stampeded into money-market funds to capture generational highs in yields. This is always a tricky proposition – cash that leaves money markets to buy stocks leaves the seller of the stocks with cash. It’s more about the urgency of buyers versus sellers of equities and whether investors allow their equity allocations to rise rather than rotate out as the market climbs. But talk of “$6 trillion in money market assets” as immediate fuel for the next up leg of a bull market is ill-considered. For one thing, $6 trillion is only about 12% of total U.S. equity market cap, near the lower end of its historical range. At the 2009 market low money markets were 50% of equity market cap. And retail money market assets (as opposed to institutional) are only $2.3 trillion, much of that standing in for bank deposits rather than poised to chase risk assets. Finally, as this breakdown of Bank of America’s wealth-management client assets shows, investors in aggregate are neither under-invested in stocks or over-allocated to cash relative to two-decade averages. The good news here is that cash rushing into stocks from money markets has never been a necessary driver of equity gains over time.
