The S&P 500 broke 5,000 points for the first time ever. The anticipation of the Federal Reserve cutting interest rates has been given much of the credit for the robust stock market rally. However, this last leg of the rally wasn’t all about the Fed and interest rate policy.
Let’s consider that the index hit its record following a gangbusters jobs report, signaling an economy strong enough to withstand higher interest rates for longer. Then Federal Reserve Chairman Jerome Powell was interviewed by the TV show “60 Minutes,” during which he essentially eliminated any hopes for a rate cut at the Fed’s March 2024 meeting.
The CME FedWatch Tool tracks the probability of Fed rate cuts. The odds have round tripped.
In October 2023, the probability of a rate cut by March 2024 was about 20 percent. The odds peaked at about 90 percent on December 22, 2023. Since then, the S&P 500 gained about five percent as the odds dropped back down to about 20 percent.
I wouldn’t go so far as to suggest that the Fed has had no influence over this last leg of the rally, but, clearly, something else is happening. I believe the stock market is reacting to improved corporate earnings.
Earnings for the S&P 500 should be about $236 per share for 2023. That is 45 percent higher than 2019. The S&P 500 was up 51 percent over that period.
The Wall Street Journal Prime Rate is up 70 percent from its low, and the yield on the 10-year Treasury has doubled. Earnings have apparently been more important than interest rates over that four-year stretch.
Clearly, the stock market did not follow a smooth path since 2019. It experienced two 25 percent declines over that period. In the longer term, it may be all about corporate earnings. But, in the shorter-term, exogenous events can crush stock prices. One such event could end up being another shock to the banking system.
NY Community Bancorp (NYCB) is the latest indication that the system hasn’t totally shaken off the March 2023 banking crisis punctuated by the failures of Silicon Valley, Signature, and First Republic Banks. Later, in 2023, Heartland Tri-State and Citizens Banks also failed.
NYCB bought parts of the failed Signature Bank, and its assets crossed the $100 billion threshold, triggering increased regulatory scrutiny and rules. As a result, the bank said it would have to make changes to its balance sheet to fit its new stature, which was a domino that tanked its stock price and credit rating.
The bank says its deposits are stable, but you can’t blame customers for feeling anxious. That anxiety was felt by investors, who cut the company’s share price in half in a matter of days.
In March 2023, during the mini banking crisis, the government used extraordinary measures to halt the domino effect of those failing banks. The Federal Deposit Insurance Corporation (FDIC) essentially said they would insure all deposits. And the Federal Reserve extended innovative borrowing tools for banks in need. The government showed that it takes banking issues seriously, so I am not overly concerned about contagion just yet. But it would be foolish of me to ignore it. The failure of a $100 billion bank isn’t just a headline; it is a game-changer for the banking system and, thus, the economy and investments.
It is my job to watch those risks. But it is also my job to size up potential rewards. There certainly have been rewards in the last few months. The S&P 500 not only hit a new record but also did so on the back of one of the indices’ strongest three-month gains ever.
So, what can history tell us about hitting new highs with such powerful momentum?
When the three-month gain of the S&P 500 ranks in the 90th or above percentile, the average returns are a bit better than all periods, according to the above chart from Bespoke. Notably, as of January 30, it reached the 99th percentile of all periods. In those instances, the returns were even better.
Although I am aware of the upside potential, it is my job to remain mindful of the risks. One of those risks is that I expect a garden-variety, but annoying, seven-to-10 percent correction in the first half of 2024. One could say we’re “due” a pullback. Since the October 2023 low through February 9, 2024, the S&P 500’s peak-to-trough decline has been just 1.98 percent, according to Bespoke. Since 1952, there have been only 15 other occurrences when the market went at least 70 days without a two percent correction. However, counterintuitively, these types of uninterrupted rallies tend to continue.
According to the above chart from Bespoke, the average one-year returns following such occurrences has been 12.69 percent, compared to 8.93 percent in all periods. The reason for this is because uninterrupted runs such as these tend to occur in bull markets. However, seven-to-10 percent drawdowns do happen during bull markets.
The components of broad stock market indices don’t all begin to fall at the same time. Like summer turning to autumn, a leaf drops from a tree, then another, then another. All the while, trees look full of life with blazing colors. Then leaves fall by the bunches as the weather turns decisively colder until trees stand bare. Similarly, for the market, stocks drop in price one by one until they take the index down. Strong participation from an index’s components is required to boost it higher. Currently, only about 60 percent of the stocks in the S&P 500 are above their 50-Day Moving Average. In other words, despite hitting all-time highs, 40 percent of the stocks in the S&P 500 are in a downdraft.
How long until the trees are all bare? It is probably too early in the season to worry about that.
My analogy falls short (this time) because it doesn’t seem as if winter is coming. Nonetheless, it doesn’t mean that a microburst won’t knock over a few trees. That fallen timber may miss your house, but it could bust up your fence. (Yes, that is a metaphorical stretch to get from a broken fence to a seven-to-10 percent correction, but you get the point.)
Still, I remain invested in stocks for a couple of reasons. First, there are no tools to precisely time such pullbacks. Second, I don’t yet see a common correction snowballing into something more significant.
Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
