Valuations are already stretched by the Fed’s rate cut

Bloomberg

For Wall Street traders whose taste for speculation only seems to get bolder by the week, Jerome Powell’s half-point rate cut was a moment of vindication.
While not a good tool for market timing, lofty valuations increase market vulnerability in the event anything else goes wrong, she says.
“A bad inflation print — like inflation moving higher — is dangerous, because it would put this cutting cycle at risk.
In the two previous instances when the Fed initiated an easing cycle with a similarly large rate cut in 2001 and 2007, the number of indicators flashing “urgency to cut” were six and five, respectively.
“The analysis suggests that a 50bps cut was easier to justify in 2001 and 2007 compared to 2024,” Reid wrote.

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Jerome Powell’s half-point rate cut was a vindication for Wall Street traders, whose taste for speculation never seems to get any bolder.

Today, as the economy is supported by a more accommodating Federal Reserve, valuation is becoming more of a factor in determining how far the festive mood can be raised.

This week, a period of intense central bank drama came to an end in the bulls’ favor as US stocks broke records, commodities rebounded, and volatility in the largest bond market in the world decreased. As investors got over their concerns that the Fed Chair had waited too long to end a two-year battle to control inflation, the Nasdaq 100 posted its best two-week gain since November.

Although valuations alone haven’t stopped the market’s upward trend in a long time, there isn’t much leeway in the current situation should investors’ large bets be derailed. Cross-asset pricing is higher now than it was at the beginning of each of the 14 prior Fed easing cycles, which were typically linked to recessions, according to a model that accounts for inflation in 10-year Treasury rates and SandP 500 earnings yields.

The chief market strategist and economist at New York Life Investments, Lauren Goodwin, believes that high prices are only one factor in an exceptionally complex market environment with a wide range of possible outcomes, including further stock market volatility. High valuations make the market more vulnerable in the event that anything else goes wrong, even though they’re not a good tool for timing the market, she says.

She said, referring to the earnings of megacap tech companies, “a disappointment from any of the Magnificent Seven on a meaningful level is a risk to valuations.”. “This cutting cycle is at risk, so a poor inflation print, such as inflation increasing, is dangerous. Naturally, anything pertaining to economic growth would also be risky for valuations. “.

Indicating that much of this week’s positive economic and policy news was already factored into riskier assets, US stocks surged to push the S&P 500’s 2024 total return above 20 percent. After the Fed lowered rates by half a percentage point and data on jobless claims indicated the labor market’s resilience, the index surged 1.7 percent on Thursday, reaching its 39th record close of the year.

Considering the performance of their main ETFs, stocks and Treasuries are expected to rise for a fifth consecutive month. Since 2006, the sequence of harmonized rallies has been the longest.

Read more: Jamie Dimon expresses skepticism about a soft landing following the rate cut; Waller notes that slowing inflation motivated him to support a large rate cut. BofA’s Hartnett advises buying bonds and gold as bubble risk returns.

Numerous stock-valuation metrics are stretched as a result of this year’s gains. One of them is the Buffett indicator, which is calculated by dividing the total market capitalization of US equities by the gross domestic product (GDP) of the country. It is currently hovering around a record high, coinciding with Warren Buffett’s recent sell-off of several well-known stock holdings, including Apple Inc. along with Bank of America Corp. says Ed Yardeni.

“Reasonable exuberance should still be justified by earnings. The founder of Yardeni Research stated that valuation is the issue. “The S&P 500 could rise to above 6,000 by the end of this year in a meltdown scenario. That would raise the possibility of a correction early in the following year, even though it would be extremely bullish in the short term. “.

Although prices have been high at times, the high levels have been easier to justify as long as earnings growth continues, which is one reason why valuations haven’t stopped the US stock market’s rally. If not, Garrett Melson, a portfolio strategist at Natixis Investment Managers Solutions, noted that the idea typically appears primarily as justification in retrospective market narratives.

According to him, it’s only when you kind of look back that you realize, “Hey, well obviously the market sold off, it was expensive.”. However, as valuations are ultimately just opinions, they are really of no use at this time. That is the nature of markets. “.

The potential for disappointment may be running high in the Treasury market, however, where futures trading continues to embed expectations for more interest-rating cuts than Fed policymakers themselves see as likely over the next year. Bond investors are placing bets on a vigorous easing program that will lower rates to about 2.8% by 2025. On the other hand, based on their median projection, policymakers estimated a higher level of 3 point 4 percent by that time.

Shortly after the Federal Reserve began its much-awaited cycle of quantitative easing, 10-year Treasury yields surged, hitting a two-week high.

Rates speculators face a problem because, despite occasional signs of weakness in the labor market, most data points are still valid. Jim Reid, a strategist at Deutsche Bank AG, ranked and sorted 16 US economic and market variables using an artificial intelligence model. Of these, only two currently suggest an urgent need for stimulus.

There were six and five indicators flashing “urgency to cut” in the two prior cases when the Fed started an easing cycle with a similarly large rate cut, which were in 2001 and 2007.

A 50bps cut was reportedly easier to defend in 2001 and 2007 than it would be in 2024, according to Reid’s analysis. “Although it doesn’t necessarily mean the Fed made the wrong decision this week, it does suggest that they are acting more proactively this time around and that their decision-making is more subjective. “.

Price action and money flows, at least for the time being, have demonstrated a strong belief in a positive economic outcome. Small-cap stocks, which are thought to be the most susceptible to fluctuations in the economy, had been rising for seven straight sessions as of Thursday, marking their longest winning run since March 2021. ETFs that track cheap-look stocks—a value style characterized by cyclical names like banks—have drawn $13 billion this month, setting up the largest inflow in over three years.

The concerns about inflation that have recently pounded bonds have mostly abated in fixed income. The so-called 10-year breakeven rate, which is one indicator of consumer price index growth expectations, dropped to 2.03 percent earlier this month, the lowest since 2021.

Though Wall Street strategists aren’t known for their caution, they already believe that the upside is exhausted, so investors who are counting on the S&P 500 to easily build on its year-to-date gain should be wary. According to the most recent Bloomberg survey, their consensus prediction for Bloomberg Terminal is 5,483, which indicates a 4 percent decline for the remainder of the year.

Client trepidation was noticed by Emily Roland, co-chief investment strategist at John Hancock Investment Management.

On Bloomberg TV, she stated, “Every week when I go out and talk with investors, they tell me that they are afraid.”. “Although it goes without saying that the cross-asset action we’re seeing with equities close to an all-time high does not reflect the lack of bullishness that I’m witnessing. “.

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