Broker Check

Post-Fed Decision Risk-Reward Considerations

March 26, 2024

The stock market rallied to new record highs in the wake of the Fed decision as investors cheered the fact that the FOMC maintained its expectation for three rate cuts this year while simultaneously up- grading their outlook for domestic economic growth. The uptick in inflation expectations was largely dismissed because as long as growth holds up, “slightly sticky” high inflation will be tolerated.

The market reaction to the Fed’s decision last week confirms the view we have held for most of 2024; as long as growth holds up, high policy rates and higher inflation will be tolerated by equity bulls. But growth is the key variable as an economic slowdown is not at all priced into the market with the S&P 500 trading above 5,200 at a never-before-sustained multiple of 21.5X expected current-year earnings.

To be sure, history has proven on multiple occasions that markets can remain irrational longer than even the most seasoned investors can remain solvent, which is why it would be a fool’s errand to try to short this market based on fundamental caution right now. There is simply too much bullish momentum behind the advance. To that point, the bullish fundamental mantra for 2024 is still intact based on the expectations for 1) imminent rate cuts this year, 2) continued disinflation, 3) resilient growth, and 4) ongoing AI optimism. All that is great and we are hopeful this rally can continue to new highs.

However, using the round number of 10% to perform a quick risk-reward assessment of the market here, the S&P 500 is up nearly 10% YTD. Another 10% gain from here would take the S&P 500 to just shy of 5,800, which would mean an extremely stretched multiple of 23.8X this year’s expected earnings. Conversely, a 10% pull- back from here would take the S&P 500 down towards 4,735, which would mean a much more reasonable multiple of 19.5X this year’s earnings.

So, if everything remains perfectly Goldilocks between economic growth, inflation, earnings, and Fed policy, there is a case to be made for that next 10% to the upside. But the number of risks to the over- extended rally here leave us skeptical about meaningful further upside and cautious (not bearish) about the YTD gains as one negative catalyst (i.e. a hot inflation print or weak growth report) could spark volatility and a pullback in stocks would likely be amplified by the combination of an increased amount of leverage in the long mega-cap tech trade, and a historically overcrowded short-volatility position. As such, I would continue to advocate for some exposure to value which we have in our annuities as well as managed accounts. When the downturn occurs, which I believe will happen in the next 4 months, it will be between 5% and 10%, but short lived as it will motivate the Fed to begin the interest rate downturns.  At that point, I will sell the value positions and move entire portfolio to growth for the rally at the end of the year. There are, obviously, no guarantees that all of this will transpire, but based on current data, I believe that is the best-case scenario.

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