Stocks have zigzagged this week as the market digested January’s higher inflation reading, leaving investors wondering whether bulls or bears will end up with the reins.
Stocks have surged since the 2022 slump, despite the sharp rise in interest rates, given speculation that the Federal Reserve would trigger a recession in its quest to fight inflation. Although that hasn’t happened (at least not yet), there’s another problem with the soft-landing scenario even if February’s inflation figures cooperate: Namely, it’s at least partially built on hopes of interest-rate cuts, but the rally’s strength alone might prevent the Fed from introducing one.
The question of when rate cuts might be coming has dominated much investor discourse over the past year. The central bank has been clear in its commitment to its inflation target, and that’s allowed consumer price data to affect equities, as seen earlier this week, when hotter-than-expected inflation led to a brief market selloff.
However, that might not be the only metric that the Fed is watching.
Yardeni Research President Ed Yardeni argues that Chairman Jerome Powell has very likely recently reread the famous “irrational exuberance” speech given by his predecessor Alan Greenspan. As many investors know, Greenspan’s remarks touched on how one can know when stocks are overextended and ripe for a fall—in some cases a long one—and what that might mean for monetary policy. Coming as it did in late 1996, several years before the dot-com bubble, Powell probably isn’t alone in revisiting the text.
“Might Powell & Co. choose not to lower the federal-funds rate at all if they conclude that a 1990s-style stock market bubble is inflating?” asks Yardeni. “We don’t know for sure, but we suspect that we might find out this year.”
He points to a few factors investors can use to spot a potential market melt-up—a swift rise in stocks fueled by FOMO, or fear of missing out.
The first is the amount of bullishness itself. Sentiment readings from the American Association of Individual Investors and Investors Intelligence Index both have bull-bear ratios that are well ahead of the average. Similarly, the put-call ratio, which measures the numbers of potential sellers and buyers (the owners of puts and calls) is also showing abnormally high bullish sentiment.
These high levels of enthusiasm may help propel the market in the near term, but could come ahead of a correction—after all bubbles happen when investors pile in without any expectation or understanding of potential downside. Therefore if they remain elevated even as indexes continually hit record highs, it could be a sign that sentiment is overheated and could crumble until fundamentals catch up.
Others have pointed to high valuations—particularly in tech—as a sign that the market has gotten too pricey and in need of a pullback.
Likewise, Yardeni notes that analysts’ expectations for long-term earnings growth can be another hallmark of extreme bullishness and melt-ups. Consensus for earnings growth over the next five years (at an annual rate) has averaged 12.5% going back to 1985, whereas it currently sits at 14.7%.
That is high, “but still well below previous melt-up peaks,” he writes. “Our hunch is that it is heading higher along with stock prices.”
Yardeni has staked a place with the optimists long term, and sees the
S&P 500
rising to 5,400 this year. Other bulls have also seen reason for caution, but not enough to abandon their position.
Fundstrat Global Advisor’s Head of Research Tom Lee noted that he’s “seeing some things that make us uncomfortable,” earlier this week, like the bond market selloff, but overall there’s reason to believe the market can keep rising.
He cites the likelihood that inflation is still trending in the right direction despite January’s hot reading, as well as bears’ swiftness in crowing over the report, which shows sentiment hasn’t in fact gotten overheated.
“This is not what makes a near-term top,” Lee wrote. “At a near-term top, we would expect investors to be adamant that this is a buyable dip….Bottom line: Stocks are seeing profit-taking, which is healthy but not a sign of a top.”
On the technical side, the S&P 500’s 1.6% gain in January means history is on the side of further gains for the whole year. The January effect holds true about 80% of the time, and nearly always in a presidential election year. Then there’s the fact that economic data are still undeniably strong, meaning stock’s advances aren’t just froth.
So while investors shouldn’t take ongoing strength for granted, the market’s exuberance doesn’t look too irrational at the moment.
Write to Teresa Rivas at [email protected]
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