Stock markets on rate-cut optimism high

The Dow and Nasdaq and the S&P 500 inched above their respective Lifetime Highs. However, New York Fed President John Williams attempted to pour cold water on aggressive rate cuts next year. In an interview Friday he said that talk of rate cuts is still “premature” and the central bank could still tighten policy if needed. These remarks supported Treasury yields. The yield on the 2-year Treasury, which is sensitive to Fed policy decisions, rose to 4.37%, while the U.S. 10-year yield is around 3.87%.

Sentiments in favour of risk

Germany’s DAX and the Euro Stoxx 50 show positive sentiments, encouraging extended long positions and elevated profit-taking risks. Conversely, the FTSE 100 and Euro Banks maintain a bearish sentiment, whereas the FTSE China A50 exhibits extended one-sided bearish positioning due to recent weaknesses. Meanwhile, Japan’s position remains mildly bullish, and the S&P/ASX 200 and MSCI EM indicate a growing bullish inclination.

Profit taking likely

Market sentiment indicates extended and one-sided long positioning following a significant uptrend in stocks since late October. While manufacturing activity fell more than anticipated in December, service sector activity exceeded expectations. Recent inflows into long positions reflect a robust bullish trend reinforced by positive cues from the Federal Reserve. This heightens the probability of significant profit-taking.

Fed rate cuts pumped markets

Over the past 13 years, substantial fiscal and monetary interventions have conditioned investors to purchase stocks at the earliest hint of market turbulence. Whether quantitative easing and zero interest rates directly impact stock prices or not, investors now instinctively link any improvement in financial conditions to the ownership of equities. Since November, there has been a remarkable surge in asset values, notably amidst heightened investor pessimism until the end of October. Within just two months, sentiments shifted from anticipating an imminent recession to embracing the likelihood of avoiding one altogether.

Monetary injections

The swift shift in sentiment is a consequence of over ten years of fiscal and monetary interventions that have disconnected financial markets from underlying economic realities. Since 2007, trillions have been consistently injected by the Federal Reserve and the Government into the financial system and the economy to stimulate growth. This influx bolstered asset prices and elevated consumer confidence, propelling economic expansion. The strong correlation between these interventions and market behavior is striking, with an exception seen only during the period just before the onset of Quantitative Easing (Q.E.) amid the Financial Crisis.

Markets disconnected from real economy

Financial markets have become increasingly detached from the broader economy. Despite a substantial surge in stock market values resulting from these monetary injections, this surge didn’t correlate with significantly amplified economic growth. Real economic expansion has merely increased since 2010, while corporate revenues saw a modest rise. This discrepancy signifies that stock prices are inflated at a rate faster than the economy and faster than corporate earnings. The Federal Reserve has conditioned investors to associate stock buying with relaxed financial conditions. This trend of market response to accommodative policies was reinforced during the ‘pandemic-era shutdown’ when extensive monetary and fiscal measures were employed by the Fed in response to market risks.

Sell stocks and hold cash?

Over the past 13 years, any indication of a Fed policy reversal has triggered a surge in equity purchases, as witnessed since October’s lows. Lower interest rates can bolster consumer confidence and drive economic activity. However, there’s a difference now. While reduced rates historically boosted asset prices, the current high government debt and deficits may limit the ability to replicate previous market interventions. With valuations much higher than in 2008, achieving prior returns in stocks could pose greater challenges.

Should we discard the warning?

Is it time to disregard the caution? A significant portion of current investors have not witnessed a true “bear market.” Many have only experienced ongoing Federal Reserve interventions, shaping an ingrained fear of missing out on future Fed support. However, looking ahead, the expectation is for reduced financial backing compared to the extensive support observed over the past decade. Investors should book profits. Historical data on inverted yield curves and Fed rate cuts, which typically indicate a shift towards selling stocks and moving funds to safer cash positions. Notably, historical instances of yield curve inversions suggest that in almost every case, investors benefited more from holding cash. Markets can change for the worse in the future.

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