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How Long Can Goldilocks Last?

May 21, 2024

The S&P 500 hit new all-time highs last week thanks to a stock and bond positive cocktail of the resumption in the decline of inflation, Fed commentary that further disavowed rate hikes, slowing growth that further pressured yields and increased rate cut expectations, and solid earnings/macro news.

 

In many ways, the sudden slowing of economic growth marks the true start of the period investors have been hoping for (and already priced in). Think about it: Growth is positive but slowing. The Fed is going to cut rates in the coming months so there’s relief coming there. Inflation is high but declining and because growth is still positive, earnings are holding up. The environment investors have been hoping for, i.e. the Goldilocks setup, has arrived!

 

Here’s the problem: It won’t last forever and, there are two ways this ultimately resolves itself. Path One: Bad Data Becomes Bad. Growth continues to slow over the coming months and it gets to the point where bad data isn’t good for stocks anymore because now it’s not signaling slowing growth, it’s signaling stalling (or contracting growth). This is the path we saw in 2000 and 2008. Understand, 2000 and 2008 were within a 16 year secular bear market. We are currently in a prolonged secular bull market. It makes a difference!

 

Path Two: Growth Reaccelerates. In this path, the Fed’s Kashkari and JPM’s Dimon are right: Rates aren’t high enough to cause a true slowing of growth that brings down inflation. So, after a small dip in growth (which we’re experiencing now), activity resumes and accelerates in the late summer and fall and the idea the Fed is going to cut rates is negated (like it’s been all year) and the idea of rate hikes and/or higher inflation.

 

Essentially this would be a bigger and more impactful repeat of the April pullback in stocks (but not necessarily a bearish gamechanger, just more volatility). This is what happened in the 1970s. Here’s the good news: Until the path the economy is taking becomes evident, there’s little to stop the upward drift in stocks. And I personally don’t think we’ll know which path the economy is taking until late summer, at the earliest.

 

Put differently, Goldilocks is here, it’s positive for stocks and given current momentum and chasing, this path of least resistance is higher, likely for the next several months (so think about it through most of summer). I say that because while growth is clearly slowing, it’ll take several more months of slow growth and further deterioration to increase concerns about a hard landing.

 

Conversely, it’s unlikely growth suddenly bounces back as it’ll take a few months for growth to trough and potentially re-accelerate. Here’s the practical takeaway: With Goldilocks here, the path of least resistance in stocks is higher for the near term and we should all enjoy that. But we have to also realize that Goldilocks arriving also commences the next phase of the economy, where higher-for -longer rates truly slows growth and causes a stall (or contraction) or we learn rates aren’t high enough and we have to confront higher rates later in the year. I doubt that because the Fed is aware of the consequences to the economy if they restart rate increases.

 

From a tactical standpoint, the way I believe we position for this environment is maintain risk exposure (because the path of least resistance for stocks is higher with) but continue to work to lower volatility via lower beta/ defensive sectors. That keeps our proverbial “boat” rising with the tide yet insulates us from sudden volatility if/when data begins to show which path the economy is taking.

 

Goldilocks is here and that’s a good thing. But it’s also drawing closer the ultimate resolution of the Fed’s hiking cycle. And while we enjoy a supportive stock/bond environment right now, don’t confuse that with a set up that can’t get more volatile in the coming months.

 

This is an election year and depending on who wins may make a huge difference in the economic and market environment as it did in 2016. If you remember the market was flat that year and only after the election did the market, take off. I had predicted at that time that if Hillary was elected that we should expect a 20% downturn in stocks. So, elections can have an impact on markets. Expect that same phenomenon this year. If President Biden wins, expect a severe downturn due to his tax policies and border policies. If Trump wins, I expect a new economic environment that would be pro-business and pro oil. I would also expect further tax reduction and border security. All these policies should have a major positive impact on stocks. 


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