Why the “easy money” part of the stock market rally is over—and what’s next

A revitalized stock market rally in 2023 finally fizzled out last week. And it could take some time to get back on track in the face of dwindling market liquidity and signs that a wave of buying fueled by “fear of missing out” has largely run its course.

“We don’t think the rally is over, but it could be difficult ‘to continue in the coming weeks’ with cash flowing out of the system,” said Michael Arone, chief investment strategist for US SPDR Business. at State Street Global. Counselors, in telephone interview.

He pointed to a “trifecta” of events that have or will likely continue to undermine liquidity:

  • Estimated quarterly corporate taxes were due from June 15. These payments come from banks’ demand deposits and go to the Treasury, removing liquidity from the financial system.
  • The Treasury Department continues to issue treasury bills to replenish the general treasury account, which was depleted before the resolution of the debt ceiling showdown in Congress in early June. While about half of the demand comes from cash parked by money market funds in the Federal Reserve’s reverse repo facility, the other half comes from bank deposits, adding to the drain on cash, said Arone.
  • The Fed’s so-called quantitative tightening process, in which the central bank allows Treasuries and mortgage-backed securities to exit its balance sheet without reinvesting the proceeds, is expected to drain an additional $55 billion from the system into the coming weeks.

The S&P 500 Index


fell 1.4% last week, ending a streak of five straight weekly gains after stabilizing at a 14-month high alongside the Nasdaq Composite


June 15. The Nasdaq fell 1.4% last week, while the Dow Jones Industrial Average


lose 1.7%. This is the biggest weekly decline for the three major indices since the week ending March 10, according to Dow Jones Market Data.

The setback was seen by many analysts as overdue given the nearly 15% rally in the S&P 500 from its 2023 closing low set on March 13. frenzy for games related to artificial intelligence.

“The rapid move in stocks has created overbought conditions and arguably went ‘too far too fast,'” Mark Hackett, head of investment research at Nationwide, said in a note. “This sets the stage for a pause or consolidation of near-term gains, although as we approach second-quarter earnings season, we are reminded that the fundamentals are significantly better than perceived. feared.”

Must know: The AI ​​boom will stay with the S&P 500, says one of Wall Street’s most pessimistic companies heading into 2023

Meanwhile, much of the buying that helped fuel the surge appeared to have come from fund managers and other professional investors who missed the rally – a phenomenon known as the “pain trade”.

“Much of the past month and more has been FOMO, meltdown, short coverage — pick your shot as you see fit,” said Huw Roberts, head of analytics at research platform Quant Insight. FOMO is the acronym for “fear of missing out”.

For professional fund managers, this fear can be fueled by disappointed clients and bosses.

“You can miss one-month performance, but we all know the importance of fixed calendar points,” Roberts told MarketWatch, referring to the impending end of the month, quarter and first half. “For any fund manager still underweight technology, how do you justify your fees in this scenario?”

The S&P 500 rally has been accompanied by improving macroeconomic fundamentals, Roberts said. The gains, however, outpaced the improving macro backdrop, likely due to those catch-up buying, much of which appears to have run its course, Roberts said.

Meanwhile, Quant Insight’s macro model sees the fair value of the S&P 500 near 4,350, slightly below its current level and likely warranting near-term consolidation, he said (see chart below). ).

What will it take for the rally to resume?

Arone argued that the S&P 500’s break above previously strong resistance around 4,200 came after the resolution of the debt ceiling showdown averted a potentially catastrophic federal default.

Market participants also believed the stage was set for a long “pause” in interest rate hikes by the Federal Reserve and had grown increasingly optimistic about the economy’s ability to avoid a deep recession. .

See: Economist who anticipated bank failures this spring says U.S. recession could be imminent

The Fed left interest rates unchanged at its June meeting, but a long pause now seems unlikely after Chairman Jerome Powell reiterated this week that a “strong majority” of policymakers were considering two more rate hikes. by a quarter of a percentage point.

Read: Bond market recession indicator points to ‘problems ahead’ for US economy

Now investors are worried about whether a pair of interest rate hikes will “advance the timing of the recession or make it worse,” Arone said. “Clarity on these things is critically important.”

Check: US stocks set to punish selling as ‘unknown unknowns’ could drive market lower, JPMorgan analysts warn

State Street sees room for stocks to extend the rally later this year, but expects a bumpier trajectory in the near term.

And for the rally to be sustainable, it will have to widen. Although the magnitude has improved somewhat in recent weeks, the equal-weighted measure of the S&P 500 remains up just 3.4% so far this year, compared to a gain of more than 13% for the market capitalization weighted index.

That means more gains are needed for cyclically-oriented stocks, small-cap stocks, value stocks and other parts of the market that have lagged the tech-driven rally, Arone said. These stocks are more sensitive to the economy, which highlights the importance of clarity on the outlook for the economy and the threat of a recession.

The week ahead is relatively light on US economic data, but features the Personal Consumption Expenditure Index for May on Friday, which includes the Fed’s preferred inflation measure.

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