Powell’s rate cut fuels rally, but valuation risks loom

Wall Street's rally continues as Jerome Powell's half-point rate cut fuels optimism, pushing US stocks to record highs. However, elevated valuations pose risks as cross-asset pricing hits unprecedented levels, leaving investors vulnerable to market shifts. Megacap tech earnings, inflation, and economic growth remain key factors that could disrupt the bull run. Meanwhile, bond traders anticipate further rate cuts despite policymakers signalling caution. With valuations stretched, market correction risks loom large despite current exuberance..Sign up for your early morning brew of the BizNews Insider to keep you up to speed with the content that matters. The newsletter will land in your inbox at 5:30am weekdays. Register here..By Lu Wang and Isabelle Lee.For Wall Street traders whose taste for speculation only seems to get bolder by the week, Jerome Powell's half-point rate cut was a moment of vindication. .___STEADY_PAYWALL___.Now, with a newly accommodative Federal Reserve buttressing the economic outlook, another variable — valuation — is emerging as the larger challenge in determining how far the celebratory spirit can be pushed..A stretch of high central-bank drama resolved in favor of the bulls this week, with US stocks hitting records, commodities surging anew and volatility in the world's biggest bond market easing. The Nasdaq 100 posted its best two-week advance since November as investors shook off concern the Fed chief had waited too long to end a two-year battle to subdue inflation..While it's been a long time since valuations alone have been an obstacle to the market's upward progress, the current situation leaves scant room for error should something happen to derail investors' big bets. A model that adjusts S&P 500 earnings yields and 10-year Treasury rates for inflation shows cross-asset pricing is higher now than at the start of all previous 14 Fed easing cycles — periods that were usually associated with recessions. .To Lauren Goodwin, economist and chief market strategist at New York Life Investments, high prices are just one element contributing to an especially complex market environment where the variety of potential outcomes — including that stocks keep rallying — is wide. While not a good tool for market timing, lofty valuations increase market vulnerability in the event anything else goes wrong, she says..Read more: 🔒 The Economist: Why the federal reserve has gambled on a big interest-rate cut."A disappointment from any of the Magnificent Seven on a meaningful level is a risk to valuations," she said, referring to megacap tech company earnings. "A bad inflation print — like inflation moving higher — is dangerous, because it would put this cutting cycle at risk. And then of course anything with respect to economic growth would be dangerous for valuations.".US stocks rallied to push the S&P 500's total return for 2024 above 20%, a sign that however good the economic and policy news was this week, a lot of it was already priced in to risk assets. The index jumped 1.7% on Thursday, notching its 39th record close of the year, after the Fed cut rates by half a percentage point and data on jobless claims signaled labor market resilience..Both stocks and Treasuries are headed for a fifth straight month of gains, going by the performance of their major ETFs. That's the longest streak of harmonized rallies since 2006..The gains this year have left many stock-valuation measures stretched. Among them is something known as the Buffett indicator, which divides the total market capitalization of US stocks by the total dollar value of the nation's gross domestic product. It's sitting near a record high at a time when Warren Buffett himself has recently cut a few high-profile equity holdings including Apple Inc. and Bank of America Corp., notes Ed Yardeni.."Earnings should continue to justify rational exuberance. The problem is valuation," said the founder of Yardeni Research. "In a meltup scenario, the S&P 500 could soar to above 6,000 by the end of this year. While that would be very bullish in the near term, it would increase the likelihood of a correction early next year.".Read more: 🔒 US investors bullish on Fed rate cut prospects ahead of earnings, elections.One reason valuations haven't hindered the rally in US stocks is that as pricey as they have appeared at any given time, the lofty levels have been easier to justify with earnings growth keeping up the pace. Otherwise, the concept tends to show up mainly as a rationale in retrospective market narratives, said Garrett Melson, a portfolio strategist at Natixis Investment Managers Solutions.."It's only when you kind of look back and say, 'Hey, well obviously the market sold off, it was expensive,'" he said. "But at the moment it's really not useful at all because at the end of the day, valuations are an opinion. That's how markets function.".The potential for disappointment may be running high in the Treasury market, however, where futures trading continues to embed expectations for more interest-rating cuts than Fed policymakers themselves see as likely over the next year. Bond traders are betting on an aggressive easing that'll drive rates down to roughly 2.8% by 2025. By contrast, policymakers penciled in a higher level of 3.4% by then, according to their median forecast. .Just days after the Fed kicked off its widely anticipated easing cycle, 10-year Treasury yields climbed, reaching a two-week high. .An issue for rates speculators is that while the labor market has shown intermittent weakness, most data remains sound. Deutsche Bank AG strategist Jim Reid used an artificial intelligence model to sort and rank 16 US economic and market variables — from consumer prices to retail sales — and found that just two currently imply an urgent need for stimulus. .Read more: Stocks soar on Fed rate cut speculation, best rally since November.In the two previous instances when the Fed initiated an easing cycle with a similarly large rate cut in 2001 and 2007, the number of indicators flashing "urgency to cut" were six and five, respectively. ."The analysis suggests that a 50bps cut was easier to justify in 2001 and 2007 compared to 2024," Reid wrote. "While this doesn't necessarily mean this week's cut was incorrect, it implies the Fed are being more preemptive this time round and suggests a greater degree of subjectivity in their decision-making.".For now at least, price action and money flows have shown clear conviction on a benign economic outcome. Small-cap stocks, seen most sensitive to economic swings, rose for seven straight sessions through Thursday — the longest winning streak since March 2021. ETFs focused on cheap-look stocks, the value style that's dominated by cyclical names such as banks, have attracted $13 billion this month, poised for the largest inflow in more than three years. .In fixed income, inflation fears that battered bonds in recent years have largely subsided. Earlier this month, the so-called 10-year breakeven rate — one gauge of expectations of consumer price index increases — fell to 2.03%, the lowest level since 2021. .But anyone expecting the S&P 500 to build easily on its year-to-date gain should consider that Wall Street's own strategists — never famous for their caution — already see the upside exhausted. Their consensus prediction in the latest Bloomberg survey is 5,483, implying a decline of 4% for the rest of the year. .Emily Roland, co-chief investment strategist at John Hancock Investment Management, sensed that trepidation among clients. ."When I'm out talking with investors every week, they're telling me that they're fearful," she said on Bloomberg TV. "I'm not seeing a lot of bullishness, but of course, that's not being reflected in a cross-asset action that we're seeing with equities near all-time high.".Read also:.Gold hits $2,300 record on Fed rate cut expectations🔒 Federal Reserve signals prolonged restrictive stance, open door to potential rate cuts in 2024🔒 Global investors contemplate fallout from US rates reaching 6%.© 2024 Bloomberg L.P.

Powell’s rate cut fuels rally, but valuation risks loom

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