Why Don’t Stocks Drop on Bad News?
The S&P 500 reached a new all-time high despite the reality that news last week was more negative than positive, but it wasn’t negative enough to shake investors belief in the “stock positive” setup of 1) Solid growth and 2) Fed rate cuts. For much of 2024, I’ve maintained that there are real risks to this rally, but with growth solid and the Fed expected to cut rates, the “burden of proof” remained squarely on the bears. To date, that burden of proof has not been met and as a result, the default direction of stocks remains higher and we saw that last week despite more “bad” news than good news.
Last week, here were some of the potentially negative headlines. 1) Israel is still planning a substantial and surprising response to Iran’s missile attack from two weeks ago. 2) CPI rose for the first time this year and it wasn’t driven by a one-off event. 3) Jobless claims spiked to summer highs, reminding investors that the labor market is in flux. 4) While bank earnings powered stocks higher Friday, consumer-related earnings were mixed (Domino’s Pizza and Pepsi were more cautious). 5) Fed officials forcefully pointed to 50 bps of cuts, not 75 bps.
The positive headlines were much sparser and were mostly limited to 1) Positive bank earnings and 2) Extenuating circumstances that are allowing investors to “explain away” last week’s stagflation data. Yet, the S&P 500 rallied more than 1% and hit a new high simply because none of these headlines are strong enough to shake investors’ beliefs in a soft landing and continued Fed rate cuts.
However, while last week’s ostensible negatives didn’t cause a decline, people who are nervous about the markets or the economy are not unreasonable, either. First and foremost, valuations are extremely stretched and while they won’t cause a market decline by themselves, they do leave this market vulnerable to a substantial (5% -10%) air pocket. Second, there are real signs the economy is losing momentum, including the wavering labor market data, flat business spending and cautious consumer spending data, and corporate commentary. Finally, geopolitical risks haven’t derailed the rally but clearly there are real geopolitical and domestic political risks that, if they go bad, should hit stocks hard.
But they simply aren’t bad enough (yet?) to derail this rally or break investors belief that the stock-positive environment of 1) Stable growth and 2) Fed rate cuts will continue for the foreseeable future. Throughout 2024, my strategy for navigating an environment where serious risks are real (economic slowdown, geopolitical crises, Fed keeping rates higher than expected) but not real enough to break up the bullish reality of stable growth and solid earnings has been to maintain long stock exposure, but to continually shift towards more value, quality and defensive sectors. That strategy, especially in Q3, outperformed, and I believe that strategy remains appropriate for a market that currently has a still-bullish set up but that faces real risks that have potentially substantial consequences while sitting at valuations that leave no room for error.
So, I continue to prefer to maintain long exposure and adding new capital (or rotation capital) to quality factor ETFs (QUAL), minimum volatility ETFs (USMV/SPLV), value styles (VTV) and defensive/value sectors. If none of these risks materialize and the S&P 500 ascends to 6,000, perhaps these allocations will slightly underperform, but they will likely still rally. However, if these risks do materialize, they should decline much less than some of the still more richly valued and higher-beta sectors. I will be moving to these funds as I see how you want me to manage the risk.
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