The stock market's run to a new record in the year's third week is a clear vote of confidence backed by a faint note of dissonance. The S & P 500 pushing to a fresh record for the first time in two years and two weeks suggests its recent pause was more stutter-step than stumble and that the benign economic mix of an advancing consumer economy and retreating inflation remains in place for now. The long wait between S & P 500 all-time highs is a friendly factor for forward performance, as far as historical observations go. Many "when this, then that" studies say so, even if they generally capture a modest sample of observations. .SPX mountain 2022-01-03 S & P 500 since 2022 high Ned Davis Research counts 14 times in the past 95 years when the index made its first new high in more than a year when there was at least a 20% decline in the interim. Ensuing returns were better than average over 1, 3, 6 and twelve months following. A year out, the median gain was above 13% and there was only one decline out of the fourteen (a big one, as it happens, from May 2007 into the start of the Great Financial Crisis). The point is not that the heavens are guaranteed from here, but that the achievement of the first new high after a prolonged setback is not typically an immediate peak, no matter how easy it is to type the words "double top" on a chart. (Beyond the two-year round-trip element, stocks' behavior as 2023 gave way to 2024 offers some reassurance. Market technician Wayne Whaley, who has developed several pattern-based and seasonal signals, has a Turn of the Year Barometer tracking the S & P's performance from Nov. 19 to Jan. 19 each year. This year the index was up 7.2% over that stretch. Whaley says that since 1950 when the index has gained more than 3% over the period, the following 12 months have been up 35 of 37 times for an average 16.5% gain "with 2 single digit losses." One of those was 2018, the other 1987.) Not just rate-cut optimism When the S & P was at roughly today's level two years ago, little did investors know it was walking into the nastiest inflation episode in 50 years, five percentage points of Fed tightening, a run in 10-year Treasury yields from 1.5% to 5% and stagnant-to-down corporate-earnings over that span. Foresight still eludes us, but it's fair to say that what's now known or plausibly believed about all those factors has them moving in a friendlier direction. I've been arguing for a while that the late-2023 downward push in inflation readings combined with the Federal Reserve's expressed willingness to trim rates even in a healthy economy meant good economic news should be good news for stocks. This is more or less playing out in the market action, with upside surprises to retail sales last week and an uptick in industrial production keeping fourth-quarter real-GDP estimates well above a 2% annual pace. A related point repeatedly struck here is that just because Fed funds futures had started pricing in 1.5 percentage points or so of rate cuts by the end of 2024 and the S & P was holding near its highs, didn't mean stocks were being held aloft merely by the distant and fuzzy guesstimate of deep rate cuts. This can't be proven — the market doesn't reveal exactly why it is where it is. But the sturdy economic macro data and noncommittal Fed-speaker rhetoric recently have dragged the odds of a March rate cut down from near 90% four weeks ago to around 50% by last Friday. And still the S & P has hung in there. But what about market breadth? The caveat here – the note of dissonance mentioned at the top – is that the majority of stocks have not done as well since late December, market breadth has again turned soft, the mega-cap leadership that was so glaring and so derided for most of 2023 reasserted. Nvidia alone has added $250 billion in market value in three weeks, good for nearly half of the S & P 500's net advance. I've never been a "breadth truther," haven't argued that mega-cap dominance was inherently unhealthy or undermined the tape's bull-market credentials. And, once again, it seems the universal applause at the fourth-quarter comeback of the majority of stocks showed professional investors want the broadening almost too desperately for it to occur on cue without challenge. John Kolovos of Macro Risk Advisors says, "It is OK to be bullish on the stock market (S & P 500) just not the market of stocks (everything else)," from a trend-following perspective. He believes the market is again showing that "interest rates and breadth are inversely related." In other words, the average stock, the more cyclical and less predictably profitable smaller stocks, are more sensitive to the squeeze-and-release dynamics of financial conditions, at least on a day-to-day basis. The 10-year yield migrating from 3.8% back above 4.1% is a mild challenge, still in the range of routine profit-taking after the year-end buying panic in bonds. Maybe above 4.25% would again flare those "Can the economy handle this?" questions and the ghosts of "too much Treasury supply." But for now, things seem digestible. The 30-year mortgage rate just had its largest 12-week drop in decades, so the rate-sensitive parts of the economy have seen some pressure lift. What about valuation? Equity valuation tends to make few lists of bullish factors now that the forward price/earnings ratio is above 19 again. It's true that this gauge is fattened by the pricey giants of the Nasdaq, and as we constantly hear the majority of stocks are more modestly valued, the equal-weight S & P around a 16 P/E. Barry Knapp of Ironsides Macroeconomics calculates that the equal-weight S & P is one standard deviation cheap versus the market-cap-weighted index. Knapp says, "While it is stretched, one standard deviation is unlikely to be sufficiently stretched to preclude the current trend from persisting. Tactically, the rally of the last few weeks does raise the hurdle for big tech's results the week after next just as the Fed seems likely to dampen the market's mood. That said, the equity market is likely to outperform Treasuries, until and unless the move in USTs picks up downside velocity." Notably, the equal-weight S & P stayed at a deeper and more persistent discount for four full years starting in 1995 (the last confirmed combination of a soft economic landing and tech-innovation excitement cycle). Valuation tends not to matter a whole lot in the near term if the Fed is no longer actively tightening and investors are feeling better about the path of earnings. Remarkably, the S & P 500 first pushed above 19-times forward earnings exactly four years ago, right before the Covid crash. (Remember, complaints about FAANMG dominance long predated the pandemic digital dominance phase.) Well, the S & P 500 has delivered an annualized total return near 11% in the four years since. .SPX mountain 2020-01-01 S & P 500 since Jan. 2020 Yes, I know, we saw multiple trillions in fiscal and monetary support, none of which likely lies ahead, and we had to suffer two 25%-plus declines along the way. And, granted, if the S & P 500 gets to 5000 or so, we're talking 20-times a possibly aggressive forecast of coming profits, meaning the bull case would have to rely more on multiple years of earnings growth (yes, it's still January) rather than just a one-year comeback in an economy still potentially susceptible to late-cycle risk factors. It's quite possible the market entering 2024 needed a more comprehensive reset than we've yet seen, even below the index surface. The pullback certainly brought no deep oversold conditions or a dramatic jump in fear. Still, there also hasn't been a mad chase into the record highs. Deutsche Bank notes equity inflows have been meager in recent weeks, and "positioning is not stretched in absolute terms but needs continued strong macro data and earnings." Plenty of macro data and earnings will flow this week to test the market's rational but tentative confidence in a record-setting, but imperfect rally.
