The stock market gained over 20% in the last year, and yet the valuation of the stock market (as measured by the Forward Price-to-Earnings ratio) is lower today than it was a year ago. This has been a pure earnings driven rally – meaning that the strong earnings of stocks have propelled prices, and future expectations, higher. The Q2 earnings reporting season is getting underway, and earnings growth should continue to determine the overall direction of equity market travel. Much attention will be paid to whether all the massive spending on AI computing power and infrastructure will result in equally massive future revenues.
A concern is the current rate of inflation, and the fact that markets have moved from pricing interest rate cuts to currently implying nearly 50 basis points of interest rate hikes through mid-2027. Stocks could struggle in the short term if the Federal Reserve, under new Chairman Warsh, were to hike as expected. Three reasons:
1) First, while earnings growth is more important than rates for equities, Fed tightening would weigh on the market outlook for growth.
2) Second, the AI boom has made the current cycle particularly capital-intensive, increasing the likely sensitivity to changes in the cost of capital.
3) Third, Fed tightening is one of the conditions that has marked the peaks of past high-valuation, high-concentration bull markets.
History shows that equities usually perform poorly at the start of Fed hiking cycles. The S&P 500 has generated an average 3-month return of -2% at the start of seven hiking cycles during the last few decades. However, history also shows that current trends are in investors’ favor. Since WWII, the S&P 500 has risen 77% of the time in 2H following a positive 1H. That success rate climbs to 81% when 1H gains exceed 5% (which they did in the first half of this year).
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All investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. Forward-looking statements, forecasts, and projections are based on current assumptions and expectations and are not guarantees of future results. Historical market trends and statistical observations are provided for context only. Historical patterns have not consistently predicted future market results, and there is no assurance that current market conditions will result in similar outcomes. References to artificial intelligence and related technologies are general in nature and do not imply positive investment outcomes. Companies referenced may not benefit from anticipated technological developments, and investment returns associated with such themes are not guaranteed.