On Wednesday, the S&P 500 increased by 3%, ending November up 5%. That came after a further 8% increase in October. And it indicates that the S&P is now only down 14% for the year. That's rather amazing considering that the Federal Reserve (the Fed) increased interest rates more aggressively than ever in an effort to combat inflation that reached 40-year highs. However, it might imply some overconfidence.
Why are stocks rallying?
Actually, bonds and gold have also been rising along with stocks. In fact, gold (purple line) and long-term US Treasury bonds (orange line) outperformed stocks in November.
Even more successful than stocks in November were gold and long-term government bonds. Source: Koyfin.
This, in my opinion, demonstrates that the rally has less to do with stocks specifically and more to do with the outlook for improved liquidity conditions, or how much capital is available in the economy and how simple it is to obtain it. As we detailed in this article, increasing interest rates drastically cut down on both the supply and demand for practically all asset types. Because of this, both stocks and bonds had a difficult year.
Investors are growing more optimistic about the prospects for a soft landing scenario, where the Fed slows the economy just enough to combat inflation but not enough to send it into a deep recession. The Fed is now approaching what it sees as the peak for interest rates, and economic data has so far only shown a gradual slowdown. If it can do that, liquidity conditions should start to improve and assets like equities and bonds that were severely damaged by aggressive rate hikes could rebound.
With US inflation finally displaying signs of slowing, the labor market softening in October, and Fed chairman Jerome Powell himself indicating the Fed is likely to announce a lower rate hike this month, there are new clues that support this perspective. There is even "a way to a softish landing," he added. You can see why stocks and other assets have been on such a tear when you combine that with the potential for China to relax its zero-Covid policy (which would boost both growth and inflation) and some technical factors (like buying from investors who are forced to close their short positions as markets rally, and low market liquidity exacerbating the price moves).
Time to go all-in on stocks then?
Here, you need to use caution. Although investors are betting on a gentle landing, this does not guarantee that the economy will really experience one. Since interest rate increases and their effects on the economy often have lengthy and complicated lag times, there is a good chance that the economy hasn't yet experienced the full effects of those aggressive hikes.
There is a reason why soft-landing situations have only sometimes occurred in the past: it is incredibly difficult for things to slow "just enough, but not too much" due to lead-lag effects and complex linkages between Fed policy and the economy. While aggressive rate increases frequently cause the economy to enter a recession, even if it doesn't happen all at once, they do tend to gradually reduce inflation. That would be good for Treasury bonds, but bad for stocks because it probably would have a negative effect on company earnings.
I would thus advise you against getting unduly euphoric at these levels, despite the fact that the outlook for stocks has just improved considerably and may warrant higher pricing. The Fed won't actually change course until inflation is undeniably moving in the direction of its 2% target range. We're a long way from there, and getting there will probably involve more economic suffering. You can anticipate a rapid decline in investor sentiment as well as fundamentals once that pain manifests and the economic slowdown is undeniably underway. The odds for stocks are slightly better right now, but in my opinion, now is still not the time to go all-in..
So what should you do with your portfolio?
Sure, you can own some stocks, but you might not want to go all out. Make an effort to maintain a balanced exposure across several markets, styles (not only speculative growth stocks), and industries (not simply tech) (not just US stocks). At this point in the game, value and high-quality stocks seem very appealing.
In the event that the economy does deteriorate more than what investors now anticipate, you might also want to hold a small amount of gold and US Treasury bonds. In reality, in terms of risks and potential returns, a "all-weather" portfolio like this one or even a simpler (but more flawed) 60/40 portfolio would be preferable to investing entirely in equities. And, as I've been saying all year, have some cash on hand for when genuine chances present themselves. Since there is a good possibility that they will.
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