The rally over the past six weeks has been impressive, not just because of its size (nearly 20% in the S&P 500 peak to trough) but also because of its backing, as fundamental factors of 1) very strong earnings growth and 2) Solid economic data have underwritten the rally.
But while the macroeconomic setup is clearly positive, it’s very important to remember that this is not an infallible market, and there are equally legitimate risks on the horizon. So, I want to identify those risks so we are aware of them and know what can go wrong. Importantly, I’m not going to focus on short-term risks that can cause just a pullback (like a 3%-5% dip).
Instead, I want to focus on bigger risks that pose a real threat to the rally, because they are out there. Risk 1: Stagflation does happen. The main cause of the March market swoon was concern that spiking energy prices would trigger stagflation (stagnant growth/high inflation). So far, that hasn’t happened because while inflation metrics are rising, economic growth has stayed very resilient (we’re in a run-hot economy of solid growth and elevated prices).
Meanwhile, most of the rise in inflation metrics is tied to energy/commodity prices, and most expect that when the war ends, they will drop and reverse the short-term inflation spike. However, it’s not the intensity that matters here; it’s the duration.
The U.S. economy was already facing affordability challenges, and this will make that worse. So far, the consumer has handled it. But the longer energy prices stay elevated (multiple months), the more entrenched higher inflation will become (again) and unlike Covid, people aren’t getting stimulus checks or forced savings to help offset it.
If energy and commodity prices remain elevated, then we will see broader prices rise. And if that lasts several months, then stagflation could well appear later this year. If that happens, it will be very negative for stocks and bonds.
Risk 2: The Fed Hikes Rates. There are many analogies that can be made between now and the 1970s, and one more might be that the Fed has to hike rates after cutting them. So far, the Fed is viewing inflation as temporary and driven by oil prices. But the longer prices stay elevated, the more Fed officials will fear an inflation rebound, and we’re already seeing that as the Fed is turning more hawkish. To that point, the chances of a rate hike were higher than a rate cut by year-end (although they are both low probabilities). If the Fed has to embark on a hiking campaign, then that will further pressure economic growth. And with inflation elevated, it could cause an economic slowdown. The last time the Fed had to hike rates to control inflation, the S&P 500 fell more than 20%.
Risk 3: AI Boom Goes Bust. The Q1 earnings season was undeniably spectacular, and that’s a very good thing. But a lot of the earnings growth that fueled that strong reporting season is tied to the AI boom, which is linked to the historic spending of just a few tech companies (OpenAI, Anthropic, GOOGL, AMZN, ORCL, etc.). Their spending is benefiting tech the most (as they need components such as semiconductors, servers, etc.), but it’s also benefiting virtually all sectors of the economy as the data center buildout involves companies from across industries (industrials, real estate, consumer goods, etc.).
It’s a massive stimulus program propelling growth and earnings, but it’s very concentrated. So, if the spending slows, or worse, stops, then these companies won’t be exporting an economic boom; they’ll be exporting a recession. That would be doubly bad for stocks as we’d see the multiple drop on growth concerns, and we’d have the most important sector in the market cratering.
Bottom line is that none of these three risks is imminent and the market is fundamentally strong. But stocks can go down, sustainably. I know it’s been, effectively, 20 years since it happened, but it can happen! So, while we’re enjoying the rally, I want to continue to present reasons for a reversal, so we can 1) not look like permabulls, and more importantly, 2) avoid being blindsided if the outlook turns more negative.
One final note: we are currently in a long-term secular bull market. They last from 8 years to as long as 20 years based on over 100 years of data. We started this secular bull market in 2017, so we are 9 years in. I expect this secular bull market to last at least another 4 or 5 years. That is another reason not to worry too much that we will repeat the downturn of 2007.