(Bloomberg) – Ignoring the Federal Reserve’s determination to keep raising rates and keeping them there is an extremely profitable trade on Wall Street right now. It’s trying to swim against the rise of the market, which involves risks.
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“Fighting the Fed” has actually been a winning stock market strategy for months. The S&P 500 index is up 15% since the start of the fourth quarter and 16% since its October low, putting it a striking distance from the 20% threshold that many investors define as the start of a bull market.
Meanwhile, the central bank has hiked rates three times, says more hikes are coming, and continually insists it will keep the fed funds rate high for some time. But for the stock market, the reaction was, who cares?
The bet seems to be that these hikes have been priced into stocks and that the Fed will actually be able to pull off a soft landing, where it tames inflation while the economy continues to grow. And that puts rate-wary, inflation-worried traders in the difficult position of rushing headlong into market momentum.
“What if the Fed actually won? It seems so,” said Adam Sarhan, founder of 50 Park Investments, which is long on US stocks, including beat tech stocks like chip stocks. “Investors are rewarded when they align with the underlying trend on Wall Street. Never fight the band and cut your losses.
Of course, the risk facing the herd of bullish investors was clear in Friday’s gangbuster jobs report – the possibility of stubbornly high inflation. If a healthy labor market keeps wages growing, prices may not fall. And that would prevent the Fed from pausing its most aggressive tightening cycle in decades.
Bull sectors
A reassuring factor for optimists in equities is the change in market leadership. Sectors that led this year’s rebound, such as consumer discretionary and information technology, have historically outperformed in early bull markets, according to investment research firm CFRA. The same goes for materials stocks, which have outperformed since late September.
History also says that whether or not there is a recession will be crucial for equities. Since World War II, there have been nine bear markets that have been accompanied by recessions, and on average the S&P 500 has fallen 35% compared to 28% for bear markets that have not accompanied economic downturns, according to the CFRA data.
What is particularly interesting is that there have only been three bear markets since 1948 without a recession. And each time, a new bull market started within five months of the bottom in stock prices.
Sam Stovall, chief investment strategist at CFRA, maintains his bullish call for US equities even though he thinks a shallow recession may yet occur. Its rolling 12-month target of 4,575 for the S&P 500 is 11% higher at Friday’s close.
“Could we expect a more severe bear market, or will there be a very slight downturn this year and the stock market has already bottomed out?” Stovall said. “I believe we are in a new bullish phase.”
Stovall scores a point. For equities, even in a recession, it’s the duration that really matters. The depth of real GDP declines from peak to trough is not historically correlated with the severity of stock market moves, according to Gina Martin Adams, chief equity strategist at Bloomberg Intelligence. But shorter recessions have led to faster rebounds.
Forecasters polled by Bloomberg expect the economy to contract in the second and third quarters of this year before recovering at the end of the year.
Technical rule
Even steadfast bears are getting more and more optimistic – for now.
Doug Ramsey, chief investment officer at Minneapolis-based Leuthold Group, said the company increased its equity exposure early in the year. And while he thinks the US could experience a recession later this year, he plans to participate in the final rally for now based on improving techniques.
“Historically, there has been an opportunity to make money with equities between the initial inversion of a yield curve and a peak in equities before a recession,” Ramsey said. “It seems risky to many. Some may think it’s like trying to grab some pennies in front of a steamroller, but I’m not sure that’s true. We could collect gold coins in front of a tricycle – and it might be worth it.
Longer term, Ramsey is wary of a fake head. Sectors that outperform in a soft landing scenario are often similar to those that do well before a recession. For example, materials producers and industrials — two value sectors that have held up well to this year’s recovery in growth — typically perform strongly in the six months leading up to a downturn.
Naturally, long-term optimists look beyond that. For them, a recession is increasingly unlikely and inflation is falling, which is what the Fed wanted to do. So the arrow is pointing up, and there’s no sense in fighting the gang.
“Inflation is down and we have no threat of a severe recession,” said Sarhan of 50 Park Investments. “As far as I’m concerned, the bear market for all intents and purposes is over.”
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