There are times when market aspirations and intentions are puzzling. But there are also times, like now, when what the market believes it wants is pretty transparent. Recent moves suggest that the stock market is seeking assurances that the economy is avoiding a trough, that Treasury yields will not fall any further, that the AI investment theme still has some headroom, and that inflation is heading straight for 2%, and that a pliant Federal Reserve is persuasive enough to take bold easing measures before it falls behind on softening fundamentals. That the market has come to view good economic news as positive for the stock market is illustrated by a chart from Citi strategists, which shows a sharp rise in the three-month correlation between the S&P 500 and the Citi US Economic Surprise Index. This comes after rising bond yields are no longer a threat and the Fed has said it is already in easing mode. Last week, all the Street received was more good economic news than feared and hopeful interpretations of the Fed's intentions. As a result, the S&P 500 is up 4%, within 1% of its all-time high from July, just at the top of its current two-month trading range. Back to Previous Highs The first week of September was tough, but has since become more resilient, fitting the August pattern pretty well so far. The sharp drop at the start of the month was exacerbated by a worrying monthly employment report, but has since bounced back briskly, buoyed by signs of consumer recovery, benign jobless claims, calm inflation, and a supportive message from the Fed. The S&P 500's low for the week was on Wednesday morning, exactly at the 5400 level it hit a week ago on Friday after the weak employment report. The surge came after the CPI report was largely as expected and after the presidential debate, which could have made the race tougher. .SPX YTD Separate from the bounce from 5400, Treasury yields started to rise from 14-month lows. This is likely a “sell the news” reaction to CPI by bond traders who have been riding the ferocious rally of recent weeks. Visa's CFO spoke upbeatly at the conference about spending recovering well, offsetting some of Ally Financial's concerns about credit stress among low-income borrowers. That same morning, Evercore ISI economist Ed Hyman, Wall Street's leading macro forecaster, flipped from believing a recession was imminent to a soft landing, but said the switch was a tough call given the mixed signals. The S&P 500's 5400 support level was also notable for being breached for the first time. On June 12, the day of the release of the weaker-than-expected May CPI report, which for the first time pushed market pricing in a Fed cut by September 18 to over 70%. It was the moment that shook confidence in a soft landing, and a month later the S&P peaked at an all-time high of over 5660. Fed's Fifty-Fifty Of course, a recovery to the brink of those old highs means a rise to levels where the market has repeatedly failed to find willing buyers. And after Wednesday's Fed decision suddenly looked like a fifty-fifty split between a 25-basis-point and a 50-basis-point cut, investors are sure to invite accusations of disappointment. The case for a half-point cut spread quickly over the weekend, with former Fed officials Loretta Mester and William Dudley saying they would be sympathetic to, or even persuaded by, such a move. Two articles by Fed watchers from The Wall Street Journal and The Financial Times, published simultaneously on Thursday, suggested that a 50 basis point cut would still be incompatible with a healthy economy, given that the Fed Funds rate (5.25-5.5%) is far removed from the inflation rate (around 2.5%). Historically, slower and more cautious Fed easing cycles are generally better for stocks, as faster and more urgent ones are almost exclusively associated with recessions. But the start of a half-point cut does not, in and of itself, mean a sharper pace of easing. At least, that's what stock buyers last week thought. It's a reminder that stock prices after the first rate cut of the business cycle depend in large part on whether the economy continues to grow before and after the cut, as Deutsche Bank's snapshot makes clear. Regardless of what the Fed does or says next week, it's hard to imagine the market ever fully outgrowing the ghosts of late cycle or the shadows of potential policy mistakes. “Two years of rate cuts would completely overtake the ghosts of the late stage of the business cycle and the shadows of potential policy mistakes,” said John Kolovos, chief technical market strategist at Macro Risk Advisors. [Treasury] “How yields respond to the rate-cutting cycle will be our guide,” he said. The yield has fallen a percentage point over the past month to 3.58%. “As long as yields don't fall significantly below the 3.25% support and start forming a floor, the cycle will end up being gradual and risk-friendly,” Kolovos added. Not fighting the Fed? Credit markets are holding strong. 12-month forward earnings expectations for the S&P 500 continue to soar, now approaching $270. To be sure, the market is trading at 20.9 times that level, according to FactSet, which no one would consider cheap. But the sideways fluctuations of the past two months have brought it down from 21.7 times when the S&P first reached its current level in July. The decline of mega-cap tech leadership has caused a lot of volatility, but the broader list of stocks is staying there, with over 60% of tickers in long-term uptrends. Also, the sentiment, which was pretty buoyant, has cooled off since the mid-July peak. The National Association of Active Investment Managers' equity exposure was 94% in mid-July, but is now at 82%. At the peak, bulls outnumbered bears in the American Association of Individual Investors survey by 27 percentage points, but now the gap is 10 percentage points. This setup does not necessarily translate into a luxurious cushion under the market. Last week's rally could have preempted potential positive inferences from next week's Fed moves. And, as is always said, the second half of September is historically more dangerous than the first half. So, as always, it makes sense to prepare for more abrupt macro mood shifts, but we need to recognize that for now the rule “don't fight the Fed or the tape” is a bullish mantra.
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