Bets the Fed will begin cutting interest rates sooner than expected have fueled a surge in U.S. equities, which received a tailwind from a rapid decline in Treasury yields. The S&P 500 up nearly 20% in 2023 after a monthly gain in November that was its biggest of the year.
Yet some investors believe the rise in stocks has left markets more vulnerable to reversals if consumer prices do not keep cooling or the Fed is less dovish than expected.
The S&P 500 rose 0.2% this week, marking its sixth-straight weekly increase, the longest such winning streak in about four years. The index stands at its highest closing level since March 2022.
“There is some optimism priced in on earnings and the economy and the Fed, so that has taken us to this level,” said Scott Wren, senior global market strategist at the Wells Fargo Investment Institute (WFII). With the S&P 500 near the top of its trading range, “we think there is a lot more potential for downside than upside.”
The WFII has a 2024 price target for the S&P 500 of about 4,700, or about 2% above current levels.
While the Fed is expected to keep rates steady on Wednesday for a third straight meeting, investors will watch for signs from policymakers that confirm the market’s view for rate cuts as early as March 2024. The Fed will also release its summary of economic projections, which will show officials’ rate expectations for next year. Friday’s stronger-than-expected jobs and consumer sentiment data, combined with a rise in yields, bolstered the case for those betting the Fed “could lean more hawkish” next week, said Quincy Krosby, chief global strategist for LPL Financial.
The federal funds futures market on Friday was pricing in a 46% chance of a cut at the Fed’s March meeting, and a nearly 80% chance of a cut in May, according to the CME FedWatch tool.
Many investors believe stocks can continue rising in the weeks and months ahead, with the S&P 500 just 4% from making a fresh all-time high.
Past rate cycles have shown that stocks tend to climb during the period when monetary policy is “on hold.” The S&P 500 has gained an average of 5.1% in periods that the Fed has paused its rate-hiking cycle and before the central bank’s first cut, according to an analysis of nine such periods by ClearBridge Investments.
The S&P 500’s rally has brought it back to around where it stood when the central bank last raised rates in July, “suggesting there could be upside” from current levels, ClearBridge strategists said in a Dec 4 blog post.
At the same time, a period of strong gains often sees stocks continuing to push ahead for months, according to Ryan Detrick, chief market strategist at The Carson Group. The S&P 500’s 8.9% gain in November put it in the 20 best-performing months since 1950, Detrick wrote in a recent report.
The index was higher a year later 80% of the time after those exceptional months, rising 13.3% on average, according to Detrick.
Still, the market’s recent gains could warrant caution.
Angelo Kourkafas, senior investment strategist at Edward Jones, said a hotter-than-expected number in consumer price data due out on Tuesday could drive a short-term pullback.
Stocks jumped last month after the October consumer price index was unchanged for the first time in over a year, boosting expectations the Fed was done tightening.
Investors will weigh the latest CPI data against recent numbers showing economic softening, including moderation in another key inflation gauge, the personal consumption expenditures price index.
“There are enough data points that we have a trend established that we are moving in the right direction,” Kourkafas said.