For Wall Street traders whose speculative appetite appears to be growing bolder, last week’s 50 basis point rate cut by the Federal Reserve was a vindication moment.

Now, with a new Federal Reserve easing cycle supporting the economic outlook, another variable - valuations - is becoming a bigger challenge in determining how far that optimism can go.

Last week, a series of high-profile moves by the Federal Reserve cheered bulls, sending U.S. stocks to record highs and the Nasdaq 100 index notching its biggest two-week gain since November last year.

While valuations themselves have long been a barrier to the market’s upside, the current situation leaves little room for error if something happens to derail investors’ big bets. A model that adjusts the S&P 500’s returns and the 10-year Treasury yield for inflation shows that cross-asset prices are now higher than at the start of all 14 previous Fed easing cycles, periods that are typically associated with recessions.

One indicator shows that cross-asset prices are now higher than at the start of all 14 past Fed easing cycles

For Lauren Goodwin, economist and chief market strategist at New York Life Investments, high valuations are just one of the factors that make for a particularly complex market environment with a variety of potential outcomes, including a continued rally in stocks. While high valuations aren’t a good tool for timing the market, they can increase the market’s vulnerability if something else goes wrong, she said.

“A material disappointment from any of the Big Seven would be a risk to valuations,” she said. “A bad inflation reading — higher inflation, for example — would also be dangerous because it would put this rate-cutting cycle at risk. And of course, anything to do with economic growth would be a threat to valuations.”

The S&P 500's total return in 2024 is already over 20%, suggesting that no matter how good the economic and policy benefits are, much of them have already been priced into risk assets. Judging from the performance of major ETFs, U.S. stocks and Treasuries are set to rise for the fifth consecutive month. This is the longest period of synchronized gains since 2006.

The strong gains in U.S. stocks this year have made many valuation metrics significantly stretched. That includes the so-called Buffett Indicator, which measures the total market value of U.S. stocks divided by the dollar value of U.S. gross domestic product. Yardeni noted that the indicator is approaching all-time highs at a time when Buffett himself has recently reduced his holdings in some high-profile stocks.

“Corporate earnings should continue to justify rational exuberance. The problem is valuations,” the Yardeni Research founder said. “In a melt-up scenario, the S&P 500 could surge above 6,000 by the end of the year. While this would be very bullish in the short term, it would increase the likelihood of a correction early next year.”

One reason high valuations haven’t held back the stock market’s rebound is that while current valuations appear expensive at any time, they are easier to justify when earnings growth keeps pace. That notion tends to come up primarily as a reason to review market moves, said Garrett Melson, portfolio strategist at Natixis Investment Managers Solutions.

He explained: “Valuations are really useless right now because at the end of the day, they just provide a point of view. That’s how markets work.”

However, the chances of disappointment in the Treasury market are high, as bond traders continue to price in more aggressive rate cuts from the Federal Reserve next year than policymakers expect, with them expecting rates to fall to around 2.8% by 2025. That compares with a median forecast of 3.4% by then from policymakers.

The market's implied rate cut path is more aggressive than the Fed's

The 10-year U.S. Treasury yield climbed to a two-week high, just days after the Federal Reserve launched its widely anticipated easing cycle.

One problem facing interest rate speculators is that while the labor market has shown intermittent weakness, most data remains solid. Deutsche Bank strategist Jim Reid used an artificial intelligence model to sort and rank 16 U.S. economic and market variables, from consumer prices to retail sales, and found that only two variables currently suggest that economic stimulus is urgently needed.

When the Fed initiated easing cycles with similar-sized rate cuts in 2001 and 2007, the number of indicators flashing "rate cut urgency" was 6 and 5, respectively.

“The analysis suggests that 50 basis point rate cuts in 2001 and 2007 were easier to justify than in 2024,” Reid wrote. “While this does not necessarily mean that last week’s decision to cut rates was a mistake, it does mean that the Fed was more preemptive this time around and suggests that there is a greater degree of subjectivity in their decision making.”

At least for now, market moves and fund flows have shown clear belief in a favorable economic outlook. Small-cap stocks, which are most sensitive to economic fluctuations, rose for seven consecutive trading days as of last Thursday, the longest winning streak since March 2021. ETFs focused on cheap stocks have attracted $13 billion this month, the largest inflow in more than three years. Such value funds are dominated by cyclical stocks such as banks.

Equity ETFs see biggest monthly inflows since March 2021

In fixed income, inflation concerns that have battered bonds in recent years have largely receded. The so-called 10-year breakeven rate, a measure of expectations for consumer price index growth, fell to 2.03% earlier this month, the lowest level so far in 2021.

But anyone expecting the S&P 500 to easily build higher on its year-to-date gains should consider that Wall Street strategists, never known for their caution, have seen the upside dry up. The latest Bloomberg survey puts their consensus forecast at 5,483, which would mean the S&P 500 will fall 4% for the rest of the year.

Emily Roland, co-chief investment strategist at John Hancock Investment Management, feels this fear among her clients.

“When I go out and talk to investors every week, they tell me they’re scared,” she said. “I’m not seeing a lot of bullish sentiment, but of course that’s not reflected in the cross-asset behavior we’re seeing with equities near all-time highs.”

Article forwarded from: Jinshi Data