Broker Check

Is the Bullish Argument for Stocks Becoming Unsustainable?

September 12, 2023

The “Three Pillars” of the rally (no/soft landing, disinflation, Fed almost done) remain in place, but as
I look forward to the end of this year and early 2024, I am starting to become concerned that the bullish argument is changing slightly and that the potential change will contain two mutually exclusive reasons (meaning the argument won’t make logical sense anymore and undermine the rally).

The Three Pillars of this rally have been 1) Soft/No Landing, 2) Disinflation and 3) Fed Almost Done with Rate Hikes. But I am starting to become concerned they are changing a bit to 1) Soft/No Landing, 2) Disinflation and 3) Expectation of Fed Rate Cuts. However, if going forward we have resilient economic growth, then why would the Fed cut rates?

If growth is going to stay so resilient that we should pay an 18X-19X multiple on the S&P 500 and expect 5%-10% corporate earnings growth (from $225 in ’23 to $240 in ’24) then why would the Fed cut rates in May or June of next year?

Herein lies my concern. If economic growth is going to stay resilient through the start of 2024, then there’s no reason for the Fed to cut rates and we’re stuck with higher rates for longer. Conversely, if the market is right and the Fed is going to cut rates in mid-2024, then that must mean that growth is slowing enough that it warrants a cut. Either way, one of the Three Pillars will be destroyed, and that would mean lower stock prices.

Now, I get the “Immaculate Disinflation” argument, that inflation drops back to 2% by next year and that will allow the Fed to cut rates. But I must remind you of something: Stable inflation and solid growth is not a reason for the Fed to cut rates—it’s essentially a reason for the Fed to do nothing!

Here’s why this matters. The scenario I’m talking about, where growth is so resilient the Fed doesn’t cut rates as soon as expected, has already played out this year! Remember, markets were forecasting rate cuts by the end of this year when we started 2023. The reason that hasn’t caused a drop in stocks this year is because portfolio managers had already priced in a slowdown in growth with the S&P 500 starting the year below 4,000. When that growth slowdown never came, it forced underinvested managers to increase exposure and that’s been the main driver of this rally.

But as we approach the start of Q4 and begin to look ahead to 2024, the environment is different and not nearly as favorable. An economic slowdown isn’t expected anymore. Instead, investors have priced in no economic slowdown. Additionally, the “easy” part of the inflation decline is behind us, and as such we won’t have these big drops in CPI to fuel the “Fed’s almost done/ ready to cut” narrative. Finally, sentiment and positioning are not the tailwinds they were to start 2023.

I’m not saying this is a reason to sell today or to get materially more defensive. Nor am I saying I’m outright bearish. But as I look ahead to what’s next, I am becoming concerned that the argument for sustainably higher stock prices is evolving and may contain two things that can’t exist together: Strong economic growth and Fed rate cuts.

If one of them comes into doubt in the coming months, then we will see a real pullback or correction in this market (I’d guess on the order of 5%-10% from here) and while I’m not predicting that will happen between now and year-end, I do think for the first time in a while there are legitimate negative surprises lurking. And if for some clients the pain of that 5%-10% pullback will be substantially more than any pleasure from a rally back to 4,600, then getting more defensive does have some merit between now and year-end. Understand that we have gotten more defensive and are not worried about the drop as it will be in the Nasdaq and S&P 500 which we are little exposed to. 

Economic data last week showed a still-resilient economy but also added to concerns that inflation may be bouncing back, and that weighed on stocks last week. There were three specific reports that contributed to the anxiety regarding a potential bounce back in inflation. First, weekly jobless claims remained extremely low at 216k, refuting the data we’ve seen in other labor market metrics that are pointing to a softening in the labor market. This matters because a still-tight labor market will keep upward pressure on wages, which will in turn support higher inflation. Second, the Prices Paid index in the ISM Services PMI rose to 58.9 from 56.8, joining other anecdotal price metrics as showing a bounce back over the past month. Finally, Q2 Unit Labor Costs, which measures the full cost of compensation including wages and benefits, rose to 2.2% from the initial 1.7% reading.

To be clear, none of these metrics imply that inflation is bouncing back, but the fact is the market has aggressively priced in ongoing disinflation, and that assumption is underwriting the current forecast for no more rate hikes in 2023 and rate cuts in 2024. If those two Fed assumptions prove incorrect, then this market will be vulnerable to a further decline in stocks and bonds, and that’s why these inflation metrics matter (and why Wednesday’s CPI is very important).


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