The S&P 500’s current rally is expected to lose steam due to supportive economic data favoring a prolonged higher monetary policy stance. Declines in job openings data and the ADP job report led to lower interest rates, but a robust job report and ISM data subsequently pushed rates higher. The combination of elevated interest rates, a stronger dollar, and increasing oil prices may pose challenges for the stock market, resulting in lower levels as financial conditions become more restrictive. I am Mott Capital, also known as Michael Kramer, a seasoned former buy-side trader and portfolio manager with three decades of experience. I lead Reading The Markets, where I diligently monitor the Federal Reserve, options, and fundamental factors to anticipate market movements in advance.
The S&P 500 (SPX) experienced a rebound at the beginning of last week as interest rates dropped and the value of the dollar weakened. However, as various economic data emerged throughout the week, indicating continued support for a monetary policy with higher rates for an extended period, it is likely that the rally in the bear market will lose momentum. Consequently, the S&P 500 is expected to decline further, continuing its August pullback and potentially revisiting the 4,100 level in the coming months.
The surge in the market from mid-March to mid-July may be reminiscent of one of the most remarkable bull traps, similar to the 43% surge in the Nasdaq 100 during the summer of 2000. This trap was fueled by the optimistic belief that inflation would subside, allowing the Federal Reserve to reduce interest rates and ease its monetary policy as the U.S. economy smoothly transitioned to a gentle landing. Although there may be initial indications of a potential economic slowdown, the economy remains robust and resilient, making it unlikely for the Fed to deviate from its planned path of restrictive monetary policy in the near future.
Once more, the stock market appears to interpret unfavorable developments as positive, driven by the belief that the Federal Reserve will step in to support the market as soon as signs of economic slowdown emerge. This trend of viewing “bad news” as favorable began on August 23, when weak preliminary PMI data from both Europe and the United States caused a significant decline in nominal interest rates.
In the past week, this pattern continued as weaker job opening data (JOLTS) and a disappointing ADP job report, despite substantial upward revisions for July, led to another drop in interest rates. However, on Thursday, the core PCE data point, which was in line with expectations, along with the robust PCE Core Services data excluding housing, helped stabilize rates. Furthermore, rates edged higher on Friday, driven by the stronger-than-anticipated non-farm payroll figures and the hotter-than-expected ISM manufacturing report.
If you dig deep, you can discover signs of a slight economic slowdown. Nevertheless, the data remains strong and points towards the likelihood of the market continuing its previous pattern of raising interest rates based on the yield curve and re-investing in the dollar. This is supported by economic models like the Atlanta Fed GDPNow and the Bloomberg Nowcast, which indicate that third-quarter real GDP estimates have hardly changed despite the influx of data.
This implies that both 10-year and 30-year interest rates are likely to keep rising, possibly returning to the upper bounds of the ranges established prior to the decline seen on August 23, and potentially even exceeding those levels.
Furthermore, the positive economic data, which outperformed expectations, will keep bolstering the value of the dollar. The dollar index has already recovered all the ground it lost after the disappointing JOLTS data and has returned to its peak levels as of September 1. From a technical perspective, there’s potential for the dollar index to make further gains in the short term, possibly reaching around 106, and it might even advance towards approximately 111. I elaborated on this in a recent television interview on the FOX Business channel’s program, “Making Money with Charles Payne.”
A significant number of investors often overlook the crucial role played by the strength of the dollar in influencing stock market dynamics. A robust dollar has a noteworthy impact on stock prices. It reduces the competitiveness of U.S. exports in international markets, which, in turn, weakens revenue and earnings growth for companies. Furthermore, a strong dollar tightens financial conditions by reducing leverage within the system. Notably, with the inclusion of China, the collective balance sheet of the G5 central banks, when measured in dollar terms, has been on a downward trend. A portion of this decline can be attributed to the strengthening of the dollar. This liquidity has historically exhibited a strong correlation with the performance of the S&P 500, underscoring its immense significance. The recent deviation from this historical correlation is particularly striking.
This poses a challenge for equity investors because significant shifts, such as the one observed on August 29, might suggest that the worst of the August market decline is over. However, the truth is that Tuesday’s ascent in the S&P 500 was primarily propelled by a declining dollar and lower interest rates, in addition to a negative gamma environment within the equity market linked to the options market’s positioning. These factors combined to trigger a substantial surge as dealers had to purchase the index as its value increased. It is probable that this rally will reverse in the upcoming days.
Projections for the Consumer Price Index (CPI) indicate an expected rate of 3.6% for August, 3.4% for September, and 3% for October. While these may not appear to be substantial shifts when compared to last year’s inflation rates at this time, these CPI expectations are contingent on the continued upward trajectory of oil prices. If oil prices continue to climb, these CPI projections could also rise. The longer the headline inflation rate remains above the Federal Reserve’s target of 2%, the more likely it becomes that the Fed will need to maintain higher interest rates, increasing the risk of further action by the Fed to address the situation.
Yes, Fundamentals Matter
This adds complexity to the situation because almost the entire stock market rally has been propelled by an increase in valuation multiples, rather than improvements in underlying fundamentals. For instance, the Price-to-Earnings (PE) ratio of the S&P 500 has climbed from approximately 18.1 on March 24 to around 20.8 as of September 1. If the index’s multiple were to revert to its previous level of 18.1 times the estimated earnings for 2023, which is $217.26, the index would return to trading at 3,930.
This brings us back to the role of the dollar, as the ascent in the PE ratio has primarily been the result of more accommodating financial conditions, which are closely linked to the weakening value of the dollar. Therefore, if the dollar continues to strengthen, it is likely to trigger further contraction in valuation multiples. Additionally, a stronger dollar could also have an adverse impact on overall S&P 500 earnings due to unfavorable foreign exchange dynamics.
The combination of elevated interest rates, a stronger dollar, and rising oil prices is expected to present challenges for the stock market for the remainder of the year. This could lead to a retracement in prices to lower levels and a tightening of financial conditions, possibly resulting in a return to the 4,100 level over the next couple of months, with the potential for further adjustments depending on the subsequent developments. This may come as a surprise to bullish investors who may discover that fundamentals and macroeconomic trends indeed have a significant impact on the market.
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