Animal Spirits
The S&P 500 has rallied by over 46% in the last seventeen months and has been setting new record highs. Year-to-date it’s up about 8%. Since mid-October 2022 (17 months ago) the mega-cap stocks known as the Magnificent 7 are up 116% compared to the S&P ex-the Mag 7 up 34%. This contrast indicates that the market has been on a very strong run led predominately by those mega-cap stocks. This calls into question the sustainability of the current rally in its current form and emphasizes why investors should be more focused than ever on taking a balanced approach to their portfolios.
Just recently, the market experienced a strong overall earnings report for Q4 and inflation seems to be gradually moving lower – all good for the market’s recent move higher. The softish landing or no landing scenario appears to be more and more plausible. Within the market, there are a few themes that have been fueling this run and it’s starting to feel like FOMO (Fear of Missing Out) is creeping back into the equation. And we’ve seen Bitcoin rally to new highs as well. In other words, market participants appear to be in a strong risk-on mode. The market’s volatility index, the VIX, in turn reflects this, as it remains orderly and low, indicating low levels of risk and fear currently in the market.
A couple of the leading themes that have been fueling this market involve the AI and weight-loss related drug companies. AI’s potential is still not fully known nor understood, but the stocks involved in AI are being aggressively purchased and that’s where things can get mispriced by large degrees. Only time will tell to what extent in either direction. The success of weight-loss drugs has drawn a lot of attention from people and also now a lot of competition from many drug developers.
Consumer discretionary was the best-performing sector for the month of February, up 8.7% compared to the S&P’s 5.3% return. Perhaps this represents the belief that we’re going to have no landing at all. And then there’s the momentum-based equities that have rallied the strongest year-to-date. The iShares MSCI USA Momentum Factor ETF (MTUM) is up 18.3% compared to the S&P’s 8% gain. This probably best represents the current market– just buy what’s hot and trending, valuation and possible bubble-like prices be damned. All of this seems to be indicative of financial conditions that aren’t overly tight despite a Fed Funds rate of 5.50%.
Also interesting to note: the rally year-to-date in equities and risk-on, in general, has happened despite rates moving higher and the number of expected Fed rate cuts for the year moving lower. At the start of the year, the 10yr Treasury was at 3.88% and the number of expected rate cuts stood at 6.3. The 10yr is now at about 4.08% and the number of rate cuts priced in sits at 3.8. Rates moving higher and the ever-hoped-for rate cuts being pushed out further isn’t the backdrop that you’d expect would engender the animal spirits to accelerate.
With the market’s performance increasingly concentrated and market participants chasing momentum, investors should be aware that rising asset prices may prolong the higher-for-longer interest rate policy by the Fed. We’ve seen over time that the wealth effect tends to increase the propensity for consumers to spend. This, in turn, could mean inflation remains more stubborn than hoped for. The Fed usually gets its way. It’s just a matter of how long it takes and to what degree the economy and the markets have been impacted by its monetary policy.
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