Wall Street Isn’t Buying What Powell, Economists Are Forecasting

(Bloomberg) — Defying the odds, the world’s biggest stock market has recouped all losses caused by the most disruptive monetary-tightening campaign in a generation.

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And not even recession warnings or fresh monetary threats from Jerome Powell are stopping fund managers as they join the big artificial intelligence-fueled rally.

Yet plenty on Wall Street have cause for concern. Think sobering economic signals in the bond market, rich equity valuations and febrile market patterns across decades of business cycles.

Doug Ramsey, for one, warns against complacency. The way Leuthold’s chief investment officer sees it: If the yield curve since the 1960s has it right, a recession really is coming around September — based on the persistently negative gap between three month and 10-year Treasury yields.

“Those who’ve successfully played the current rally, in part because of excessive investor pessimism, should recognize the crowd is now mostly aboard,” said Ramsey. “My biggest concern by far is the lagged impact of the last 15 months’ tightening.”

After the Federal Reserve paused hikes Wednesday, the S&P 500 closed at 4,372.59, a level seen in March 2022 when Chair Powell kicked off the hiking cycle — sparking a bear market across stocks and bonds and predictions that a recession would surely land this year.

Now stock enthusiasts are in the driving seat. Big Tech promises to fuel a fresh wave of corporate profits, inflation is easing at long last and historically speaking rate pauses have marked a key inflection point that have ushered in double-digit returns. In Thursday trading, the S&P 500 rose above the 4,400 mark for its six-day advance.

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“The bulls have the upper hand right now,” said Zachary Hill, head of portfolio management at Horizon Investments, who thinks both economists and investors have underestimated the strength of the US consumer. “The worst is behind us.”

The rise in US stocks came after equity positioning was cut to the bone amid consensus expectations for more losses at the start of 2023 before a second-half rebound. As stocks kept rallying, skeptics had to cave.

Rules-based and discretionary investors are now overweight equities for the first time since February 2022, data compiled by Deutsche Bank AG show. A survey by the National Association of Active Investment Managers shows equity exposure has doubled since early January to 90% last week.

That doesn’t mean the advance can’t keep on going. But already high equity positioning means investors have less dry powder to buy equities in the months ahead. And it’s looking choppy out there. Forecasters surveyed by Bloomberg are predicting that the economy will contract mildly in the third and fourth quarters.

Then, there’s the valuation constraint. At 19 times projected 12-month earnings, the S&P 500’s multiple is about 8% higher than its 10-year average.

Since World War II, there have been nine bear markets that have been accompanied by an economic downturn, and the S&P 500 on average has declined 35% versus 28% for bear markets that didn’t come with one, per Sam Stovall, chief investment strategist at CFRA.

Meanwhile there have been just three bear runs since 1948 without recessions — and each time a new bull rally started within five months of stock prices hitting a low.

Even if there’s a recession, it’s the length that really matters. The depth of peak-to-trough real GDP declines isn’t historically correlated to the severity of stock slumps, according to Gina Martin Adams, chief equity strategist at Bloomberg Intelligence. Yet shorter recessions have led to more rapid rebounds.

With the job market still strong, the consensus expectation is that any downturn will be mild, helping to explain why fund managers are choosing to rebuild their market exposures rather than miss out on further tech-powered gains.

“The medium-term trajectory once we get past this does not look like an economy that suffered deeper scars that will take years to heal,” said Yung-Yu Ma, chief investment strategist at BMO Wealth. “That allows for some comfort to hold onto positions, even for investors that might think we have a bumpy road ahead.”

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