For several months, we have pushed back against calls for a significant, structural decline in stocks based on the idea that there are “Three Pillars” supporting the 2023 rally in stocks and that as long as those pillars are standing, the risk of a sustained decline in stocks is low.
That thesis enabled us to push back against the bearishness in the financial media and analyst community from two weeks ago when the S&P 500 fell to May lows and threatened to test 4,000. Our argument was simple:
The three pillars were still in place, so a sustained stock decline was unlikely as fundamentals were strong.
Since those lows on October 27, the S&P 500 has rallied more than 10% at its peak and is within 3% of the 2023 highs. As we covered last week, we’re a bit skeptical of this latest rally, and the S&P 500 is now trading solidly above what we believe is “fair value,” given fundamentals, so a pullback on some negative news shouldn’t be a surprise in the near term.
But as long as the three pillars remain intact, the risk of a material and sustained decline in stocks should stay low, and as we approach the end of 2023 and look ahead to 2024, I wanted to update the status of each pillar.
Pillar 1: Soft Economic Landing. Why It Matters: A stable and growing economy is a rising tide that lifts all risk assets, while a slowing or contracting economy is a falling tide that lowers risk assets. As long as the economy is stable, then markets can trade in a solid multiple, and expectations for corporate earnings will remain strong.Update: A soft landing is still the most likely economic outcome. According to broad economic data and the Hard Landing/Soft Landing Scoreboard, there has been some slight loss of positive economic momentum, but for now, the economic data is clear:
- The U.S. economy is resilient.
- It is still growing.
- There are few signs that a material economic slowdown is near.
What to Watch For: If the “big three” economic data points (ISM Manufacturing/ISM Services and Jobs Report) suddenly turn lower, that will jeopardize this pillar and be a negative for risk assets but positive for Treasuries.
Pillar 2: Disinflation. Why It Matters: If inflation can continue to decline and return close to the Fed’s 2% target, the Fed can cut interest rates and reduce the chances of an economic slowdown.Update: The latest inflation data showed clearly that disinflation (the decline in inflation) is ongoing, although the pace of that disinflation has slowed materially. There remain concerns that inflation could bounce back or that the rate of disinflation will stall, but so far, the data shows continued, albeit slow, declines in inflation. What to Watch For: The Core PCE Price Index will be the next significant inflation data point, and if it repeats the decline we saw in last week’s Core CPI, that will offer more evidence that disinflation remains consistent (and it’ll be an incremental positive for markets).
Pillar 3: Fed Done (Or Almost Done) With Rate Hikes. Why It Matters: The longer and higher the Fed hikes rates, the greater the chances of an economic slowdown. So, the sooner the Fed is done with rate hikes, the better. Update: Last week’s lower-than-expected CPI report resulted in investors fully pricing in that the Fed is done with rate hikes, and that expectation helped to push stocks higher last week.What to Watch For: Fed commentary may push back on the idea that the Fed is absolutely done with rate hikes, but unless we see a bounce back in inflation data, markets will largely ignore Fed rhetoric, and rightly so, as they are likely done with rate hikes.
An Important Change to Watch (One of the Pillars Is Changing). The Fed is likely to confirm at the December meeting that they are “done” with rate hikes for the foreseeable future. With that confirmation, this pillar of the rally will undergo a change from “Fed Done or Almost Done” to “Rate Cuts Sooner Than Later.” That change will bring with it some new risks. Put simply, the gap between what the Fed says it plans to do (cut rates just once next year) and what the market expects it to do (cut rates 3-4 times next year) is extremely wide. Expectations for those future rate cuts absolutely pushed stocks higher last week, and in the future, any data refuting the idea of rate cuts in the first half of 2024 will erode this pillar of the rally and increase the chances of a pullback. But that’s more of a 2024 problem than an immediate one, but I did want to make you aware of this critical looming change in the structural support for this rally because it could mean volatility in early 2024.
Bottom line, the three pillars of the rally remain in place, and while in the short term, according to fundamentals, the market is a bit “over its skis,” there remains important support for stock prices, and the chances of a sustained decline remain low.