What is hiding in the closet, Bull or Bear?

What is hiding in the closet, Bull or Bear?

May 14, 2024

In 2021 we said that we believed inflation would be transitory – if your definition of transitory was a long time.  Transitory as the Fed meant it, was short term.  We believed that the trillions of dollars that were printed during Covid would have a long-term effect on inflation.  It has become clear that this is the case.  So, what does this mean for the stock markets?

The main drivers of the stock markets are company earnings and interest rates.  If earnings go up, that is a sign of a healthy economy.  If interest rates go up, that is a sign of a Fed concerned that the economy is overheating.  The cost of borrowing money becomes more expensive with higher interest rates which, in theory, should put a damper on corporate earnings and slow the economy down.

At the beginning of 2024, the Fed indicated that they would begin interest rate cuts and anticipated three 0.25% cuts in 2024 (0.75% total).  Many analysts saw 6 or more cuts in 2024, and the market rallied.  Higher earnings and lower rates were positive indicators for the stock markets.  However, although earnings have continued to grow, the Fed keeps extending the timeframe for rate cuts – this news should be at least mixed for the markets.  We seem to be in a spot where both good news (higher earnings and potential rate cuts) and bad news (extending higher rates) are all driving the markets higher.  Everything is being interpreted as good news for the markets, and this feels frothy.

Currently, stock market analysts are predicting in increase in earnings and a decrease in interest rates (more rate cuts) through 2026.  If that happens, that would be great for the stock markets.  However, if the Fed continues to delay rate cuts (and potentially raise them), that should begin to slow earnings due to higher rates via higher borrowing costs.  The stock markets would most likely interpret this as a slowing economy and market returns would decrease.  We feel that this is the most logical direction.  However, if we do experience a recession and down markets, we feel that it will be a mild one.  Market returns could be muted over the next 5 years or so, but elevated bond prices should help hold portfolios above water.  There is also an upside risk of getting too conservative – remember, markets have not been following a logical direction.

Our advice – Review your allocation to stocks and bonds.  Many portfolios have become overallocated to stocks due to high market returns.  Bring your portfolios back in line with your intended allocation and continue to rebalance at least annually.  Bonds are there to reduce volatility and become more important when the market direction is wobbly to down.  We don’t know exactly what lies ahead, so managing risk (allocation to stocks and bonds) is the best tool we have in all market conditions.