This Market Is Getting Too Hot To Touch

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A weak opening for the stock market came as no surprise yesterday after the monster run-up over the past four weeks in the major market averages. The Nasdaq Composite and Russell 2000 have now produced bull-market rebounds of more than 20% from their June lows. A disappointing report for the manufacturing sector in New York and economic data out of China that was weaker than expected both weighed on sentiment, providing investors with an excuse to take profits. The surprise was that stocks recouped their early losses to close at new rally highs by the end of the day. While I enjoy seeing my outlook for the second half of the year come to fruition, this market recovery feels like too much too soon to be sustainable. In fact, it is too hot to touch with new money at this stage, and we need a pause to refresh.

Finviz

If it feels like there is speculation in the air again, there are technical indicators suggesting we are back to levels not seen since before the pandemic. The percentage of stocks in the S&P 500 with a relative strength index (RSI) over 70 for the past 14 days is at a 2-year high. In layman’s terms, a lot of stocks have made enormous moves upward over a very short period of time. That usually starts out as short covering and evolves into a fear of missing out, which is what it feels like today. While I still see further upside ahead, the enthusiasm I had a couple of months ago has waned a bit at current levels. I would like to see the economic data catch up with the increase in overall market valuations.

Bloomberg

In order to achieve a soft landing, whereby the rate of inflation falls near the Fed’s targeted range over time without resulting in a recession, we need the rate of economic growth to slow. That is why news about weaker manufacturing data out of New York or slower economic growth in China can be perceived as positive for financial markets. Both announcements indicate weaker demand, which should be deflationary and move us closer to the Fed inflation target. The sooner growth slows and more rapid the decline in the rate of inflation, the less work the Fed has to do in the form of monetary policy tightening.

The only problem with a bullish response in markets to weaker economic data is that it works against the Fed’s effort to stymie demand and slow the rate of growth. If financial asset values increase too much, they can create enough wealth that it spurs an increase in demand. This is quite the catch-22 for Fed officials, which is why they have to talk out of both sides of their mouths more frequently than usual.

They want to avoid being pessimistic to the extent that they encourage consumers and businesses to recoil to such a degree that it results in a recession. At the same time, they want to temper enthusiasm and risk taking to the extent that it overheats the economy and drives the prices of goods and services higher. I think this is a balancing act that will continue until inflation falls to a range of 2-3%.

If the stock market continues its rapid ascent from here, the probability of more rates hikes will increase, which is the main reason I would like to see a pause that refreshes. I am still convinced that a Fed funds rate of 3% by November should result in enough deflationary progress to allow the Fed to end its rate-hike cycle. That is one of the main pillars to my bullish outlook. The bears are convinced that the Fed will have to tighten far more aggressively than 3%, which they assert will result in a recession in 2023. The historical data in the chart below explains why a 3% Fed funds rate is a pivotal number.

It is not often that the Fed raises short-term rates by as much as 3% (300 basis points) over a 12-month period. The consensus view is that such an aggressive move always results in a recession, but that could not be further from the truth. Typically, the economy expands in the year during and after the Fed raises short-term rates by as much as 350 basis points. In fact, the economy has grown in the year during and after a 200-300 basis point increase 86% of the time from 1962 to the present. The risk of recession grows demonstrably after the Fed raises rates by 350 basis points or more with the economy only expanding 17% of the time in the year that follows.

Fidelity

While some Fed officials have publicly suggested that short-term rates could go as high as 4%, we know they are simply jawboning markets. The Fed funds futures market sees the highest probability of a 3.5% peak in short-term rates. Most importantly, the bond market has been telegraphing a peak of 3-3.25% through the 2-year Treasury yield, which has oscillated between 2.85% and 3.25% over the past two months. I am leaning on the bond market as my guide, and if the 2-year yield starts to rise meaningfully from current levels, I will have to temper my enthusiasm for risk assets. For now, the balancing act continues.

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