The U.S. stock market has been rallying on hopes of a “Goldilocks” economic environment, where inflation falls and glides back down to the Federal Reserve’s 2% target, while relatively stable economic growth helps stocks and bonds log strong rallies.
That would be a continuation of a trend that started in early June, whereby economic data refuted fears of a hard landing, stubbornly high inflation and more interest-rate hikes.
Tom Essaye, founder of Sevens Report Research, said the current level of the S&P 500 SPX, +0.51%, which Thursday cleared the 4,500 mark for the first time since April 2022 and traded at 4,519 on Monday, is propelled by some “positive catalysts” that have already been factored in by investors.
He also thinks the biggest risk to this market rally over the medium term is a hard landing or a recession, which hasn’t been totally vanquished.
“While it’s undeniable that fears of a hard landing, inflation and hawkish Fed have not materialized, the reality is that the current level of the S&P 500 largely factors all of that in, so last week’s CPI and PPI reports didn’t provide the market with a new positive catalyst, but instead just reinforced what was already widely assumed,” Essaye wrote in a Monday note.
While positive economic data did create further “chasing” from underinvested managers, he thinks most of the “chasing” that’s going to happen in this market already has occurred. So, “don’t expect that to push the S&P 500 materially higher,” he said.
See: The U.S. stock-market rally seems unstoppable, so why does bearishness still persist?
The trifecta of outcomes that the stock-market investors have priced in — no hard landing, falling inflation and a Fed that won’t be raising rates much longer and possibly cutting soon — are “the best outcome” anyone in this stock market could have hoped for at the start of 2023, and that means the gains in stocks are “legitimate,” said Essaye.
However, the rally is also likely to be exhausted in the near term, and it’ll take “something else” to push stocks materially higher from here, Essaye warned. Here are three events that he thinks could drive the S&P 500 higher, and materially extend the rally.
Treasury yields fall sharply
“If the 10-year yield and the 2-year yield drop sharply towards 3% and 4%, respectively, and 10s-2s continues to rally (say back towards -50 bps), then that will ease valuation constraints, and we could see markets push for a 20X multiple on earnings, if economic data stays Goldilocks,” Essaye said. That equates to 4,800 for the S&P 500.
The yield on the 2-year Treasury TMUBMUSD02Y, 4.746% rose 2 basis points to 4.74% on Monday, while the yield on the 10-year Treasury TMUBMUSD10Y, 3.811% was up 1 basis point at 3.827%. Yields move in the opposite direction to prices.
Earnings are stronger than expected
A better-than-expected second-quarter earnings season and a higher earnings guidance for next year could drive the 2024 earnings-per-share (EPS) estimates for the S&P 500 higher, and therefore push the large-cap index to the 4,700-level, said Essaye.
For the second quarter of 2023, 6% of the companies in the S&P 500 have reported actual results as of Friday. Of these companies, 80% have reported actual EPS above estimates, which is above the 5-year average of 77% and above the 10-year average of 73%, according to FactSet.
Big banks kicked off earnings season last Friday with JPMorgan Chase & Co. JPM, +2.44%, Wells Fargo & Co. WFC, +3.01% and Citigroup Inc. C, +0.93% all reporting earnings and revenue that beat forecasts. This week, regional banks will be in the spotlight, while Tesla Inc. TSLA, +2.87% and Netflix Inc. NFLX, +1.93% are also among the companies due to report later this week.
See: The nation’s biggest banks are gearing up for more consumer struggles ahead
Another round of AI-driven enthusiasm
Essaye said the artificial intelligence (AI) was the reason stocks rallied out of the March “regional-bank crisis” as investors have loaded up on them in a “safe-haven play” on concerns over a potential recession, a federal debt-ceiling breach and more stress in regional banks.
However, it created very thin market breadth, with a group of seven stocks dubbed the Magnificent Seven accounting for most of the market gains.
“If we see another round of AI mania, the weighting of these tech stocks could push the S&P above reasonable valuation levels, although our concern about the sustainability of that rally would be extreme,” Essaye wrote. “Nonetheless, it could punch the S&P 500 higher.”
See: The ‘S&P 500 is hot, the Nasdaq is even hotter,’ says strategist. How traders are bracing for a pullback.
He also pointed out that recession concerns have not been totally vanquished as hard landings and recessions usually don’t appear until after the Fed has stopped hiking rates, so “it really isn’t a surprise one hasn’t materialized yet, and it does not mean that it won’t appear, either,” he said.
Additionally, falling inflation is a macro-economic positive, but it could negatively impact corporate earnings starting this quarter, and more likely in the third quarter, so the S&P 500 will be vulnerable to earnings disappointments at its current level.
“Bottom line, the macro-economic environment is as positive as anyone can hope for, but don’t confuse that with a ‘risk-less’ environment. It is not!”
U.S. stocks traded higher on Monday, with the S&P 500 up 0.4%, while the Dow Jones Industrial Average DJIA, +0.38% was gaining 0.2% and the Nasdaq Composite COMP, +1.02% was advancing 0.8%, according to FactSet data.