Done and Dusted
At least that’s what the market thinks when it comes to Fed hikes… and the result has been a blistering rally with the Nasdaq Composite up more than 8% since October 26th, after a three-month long pullback that clocked in at a 12.2% drop. In fact, the Nasdaq and S&P 500 have logged their longest daily win streaks since November 2021.
In true 2023 fashion, the rally has been characterized by large-cap stocks handily outperforming small-caps, and the growth stock-heavy Nasdaq outperforming the broader (though also growth-heavy) S&P 500.
As with any market inflection point, the discussion surrounding it became dominated by technicals and charting, with some hope of correctly determining the market’s direction. A couple things going for the bull case are that the S&P has again moved above its 200 day moving average, and market breadth (as measured by the number of stocks advancing versus the number declining) saw a couple days of strong surges last week, suggesting that there was broad participation in this rally.
It’s worth noting that breadth turned weaker again after those surges, despite the continued positive index moves… meaning we may already be regressing to a more concentrated, mega-cap led rally.
In any event, technicals have been only part of the puzzle. The real story of the last couple weeks has been the precipitous, and unrelenting drop in long-term Treasury yields. It’s been driven by multiple causes: The Fed staying on pause in November, weaker jobs data, a drop in oil prices that should reduce inflationary pressure, and lower than expected manufacturing and services PMIs. All of this has also resulted in market expectations of the Fed’s first rate cut being pulled forward by one month to June 2024.
Put that all together, and we get a chart like this, showing a very clear inverse relationship between stock prices and Treasury yields.
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It’s not surprising that stocks are up after a large drop in yields, and even less surprising that large-cap growth names have again led the pack, especially in recent days. A lower discount rate mathematically supports higher valuations.
The trouble is that shorter-term yields haven’t moved down nearly as much, suggesting that although the Fed may be done hiking, they’re still far from cutting. This leaves the skeptics (myself included) concerned that markets are prematurely celebrating an end to restrictive policy. The restriction remains, and many of the effects are likely yet to be seen.
Cuts Hurt More
Part of why there’s a concern that the market is prematurely celebrating is because we’ve seen this movie a few times before, and although not a perfect replica, the current market behavior resembles prior cycles. However, in many of those prior cycles, the period after the hikes end is not the most worrisome, it’s the period right around when the cuts begin that tends to bring on the most strife.
The bulls are hoping this cycle will resemble that of the mid-90s, when there was no subsequent market low after the hikes ended. In fact, the low occurred on the same day as the last hike, and the market was basically up for the duration.
If the last hike of this cycle was in fact on July 26th of this year, the S&P is actually down 4.1% since then. But if we start the clock when markets stopped expecting any additional hikes around mid-October, the S&P is up 2.3% since then.
One could argue that this may turn out to be a similar experience to the mid-90s, when hikes ended, no recession ensued, and the market moved higher for the better part of the next five years.
One could also argue that this hiking cycle has been so much more aggressive that the pain of it is also likely to be worse, and the results may look more like the negative observations.
No Certainties, Only Guesses
The truth is, no one really knows. Even the historical time frames of the table above have inconsistencies. The clearer takeaway is that the column showing market returns between the last hike and the first cut is decidedly more positive than the column showing returns from the first cut to the subsequent market low. And there usually is a subsequent low.
As such, staying vigilant and cautious makes the most sense to me. If July was the last hike, we are squarely in that purgatory period between hikes and cuts, when markets have more often than not held up pretty well. So perhaps we’re in the clear for now. But once those cuts draw nearer, the odds of things holding up are lower.
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