Screenwriters refer to “second-act problems.” After the characters and the stakes of a story are established in the first act, things can get a bit messy and confusing as the central conflict is escalated before pushing toward an ultimate resolution. The markets have entered such a muddled middle phase after a first quarter in which the plot lines were neat and tidy and the rally free of complications. The first act of 2024 had the consensus embrace a story of brisk economic growth, a strong and rebalancing labor market, ebbing inflation, an upswing in earnings growth, repeated record highs in stock prices and the prospect of a Federal Reserve looking to trim rates into all this. Much of this remains either true or plausible, still. Yet a third straight warmer-than-expected CPI reading last week reawakened bond-market volatility, gave an extra push to a revived reflation-asset trade and resurfaced concerns that imperfect tradeoffs might need to be made among growth, inflation, valuation and Fed policy. The result was a 1.5-percent weekly drop in the S & P 500 , with Friday’s setback exacerbated at least somewhat by a collective clenching-up of risk markets on some geopolitical worry. Rally tested A week after the S & P ended its first 2% dip in more than five months, an early hint of a potential change in market character , the index retreated to touch its 50-day moving average for the first time since November. It did, however, bounce off that line to close above it for the 110 th straight session, according to Bespoke, making it one of the dozen or so longest such streaks in the past 80 years. Consider this test of the rally’s resilience ongoing rather than settled. I’ve repeatedly said this has not principally been a Fed-driven market, in the sense that it didn’t “need” rate cuts to happen soon or to be deep in order to stay supported given the otherwise sturdy macro. This doesn’t mean the market could easily shrug off the circumstances under which the Fed would retreat from its easing bias altogether this year. That’s because the Fed merely needs inflation to settle down just a bit — even in a still-strong economy — in order to punctuate the tightening cycle with a “normalization” cut or two. So, if there are no cuts, it means inflation will be more stubborn, which probably means longer-term yields would keep threatening to pinch equity progress. Remember, the pivot toward an easing bias by Chair Jerome Powell late last year was so avidly embraced by the market because it meant the Fed no longer saw the need to smother growth in order to suppress inflation. Before then, Powell was routinely saying the economy needed to run “below potential for a sustained period” to corral inflation. He would frequently point out that services-sector inflation was really about wage growth, so the job market might need to soften up a lot to drag down prices there. This is why the appreciable drop in inflation by November — a steeper decline than the Fed had been forecasting — immediately freed Wall Street to treat good economic news as good news for stocks. This dynamic hasn’t been reversed, but the signal has grown a bit staticky, draining some conviction from the macro bullish case with the S & P 500 still 24% above the October low. Jumping yields, gold The jumpiness in the bond market manifests some of this dissonance. The ICE BofA MOVE Index , the VIX of the Treasury market, so to speak, bottomed at a two-year low on March 28, the date of the last all-time high in the S & P 500, and has shot higher since as the 10-year yield vaulted 4.5%, before settling a bit with that geopolitical bid on Friday. .MOVE 5Y mountain ICE BofAML MOVE Index, 5 years A torrent of hedging activity also washed over the equity-option and VIX futures market, a sign that traders are eager to pay up to protect gains. Gold has gone nearly vertical this month, with stupendous volumes in the SPDR Gold Shares (GLD) ETF Friday just as the gold price put in a possible short-term buying crescendo, rushing from $2,400 an ounce to $2,440 before recoiling to $2,360. @GC.1 1Y mountain Gold, 1-year This twitchy cross-asset action at some point could reflect a helpful upwelling of trader anxiety and a rebuilding of a wall of worry, though the middle of the squall is no occasion for such a confident forecast. In such a period of flux, when it’s a struggle to bridge the story from setup to satisfying conclusion, it helps to return to the outline by stacking up what we know, or are pretty sure of, about the current backdrop. Bull market’s backdrop First, it’s a bull market, and not a particularly mature or excessively generous one yet. Whether one dates it to the ultimate October 2022 S & P 500 low or, as some prefer, to last October when market breadth bottomed, the trend is higher, the overshoots tend to happen to the upside, the pullbacks are ultimately contained and buyable. The rare persistence and breadth of the rally (up 10% two straight quarters, no 2% dip in five months) from October 2023 through March strongly suggests an ultimate peak has not been reached, based on any number of studies of past markets that behaved similarly. Even so, as I wrote here two weeks ago when I recited some of those stats, “In those prior 11 times the S & P entered the second quarter up at least 10%, the smallest pullback the rest of the year was 4%, and those were in the 1960s.” The smallest setback in recent decades during such years was more than 6%. We’re now in a 2.7% pullback. It’s safe to surmise that at some point the market was going to seize on some set of credible excuses to undergo a decent little shakeout at minimum. Not to suggest the stickiness in CPI inflation is a mere empty excuse, but some perspective on the inflation picture is worth a mention. There should still be lagging disinflation in shelter running through coming reports. And more crucially, the Fed’s 2% inflation target is based on the PCE measure, whose consumption-based weightings have taken it lower than CPI. Economists see the core PCE annualized gain coming in around 2.8% (the report is due in two weeks). The Fed members’ latest median forecast for core PCE at year-end was 2.6%, and their median expected number of rate cuts this year was three. This is not a vast distance to travel to set the stage for one of those “optional” rate cuts to occur. The rethink of the Fed path has done nothing to interrupt the corporate-earnings recovery now anticipated, and probably required in order to validate current full valuations. FactSet’s John Butters figures first-quarter S & P 500 earnings growth will exceed 7% over the prior year, based strictly on the average margin of outperformance versus forecasts seen over the past four reporting periods. The market reactions will be noisy and will expose pockets of “excess belief” among investors in certain favorite themes. When Fastenal fell short of expectations last Thursday, shares of this play on big industrial-capex themes fell 6.5% and dragged down WW Grainger 3.5%. Yet both stocks are still outperforming the S & P this year. As Citi US equity strategist Scott Chronert put it on Friday, “Markets have priced in a higher probability of the Goldilocks scenario playing out this year, introducing more downside risk to ‘good but not good enough’ news… A buying opportunity may present as we progress through the reporting period if we see consistent positive surprises followed up with a rightsizing of market implied growth expectations.” Tactically, with short-term momentum broken, a reset of attitudes is underway. The S & P 500 closed Friday at exactly the same level of five weeks earlier, on March 8 – which was perhaps the moment of maximum investor confidence in the “we can have it all” thesis. The day before, Powell had said the Fed was “not far” from being able to trim rates, then on the 8 th a near-perfect employment report cemented the soft-landing consensus. The market, in its way, is doubling back to test these premises.
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