Sentiment’s ability to influence the direction of markets has been fully demonstrated over the past week. Investors emerged from the depths of darkness and found price-supportive bright spots even in murky news.
Most important was the interpretation of Federal Reserve Chair Jerome Powell’s comments on Wednesday after the Fed hiked interest rates by 0.75 percentage points. Mr. Powell eventually stopped offering guidance on how the Fed might move forward, gave no assurances that a recession could be avoided, and when asked about next year’s rate cuts, referred to last month’s forecast that rates in 2023 would continue to rise.
The markets have ignored all this. All they heard was his admission that the economy appears to be slowing (though he questioned the accuracy of the GDP data). Bond yields fell and the Nasdaq Composite rose 4%, the biggest one-day gain since the pandemic rebounded in April 2020, as investors bet for even faster rate cuts next year than they had already anticipated. The markets are fighting the Fed.
Investors were prepared to be on the lookout for good news because they were so down. The dismal bang this year drove prices lower, but it also meant worse news was needed to push them lower. When everything looks gloomy, the slightest break in the clouds looks like a new day.
Something similar happened to Big Tech’s quarterly earnings the day before. Alphabet, née Google, has disappointed on both earnings and sales, which usually result in stock price declines. Instead, investors focused on search advertising, a rare bright spot in an otherwise poor report.
It wasn’t a very bright spot: Google advertising was just 0.9% above forecasts. But that was enough for a price jump of 5%. Investors had braced themselves for even worse numbers than Wall Street analysts, so it took little to please them. Microsoft disappointed on earnings and sales across the board, but investors ignored the report and focused on the optimistic outlook, and together they helped boost the overall market.
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It sounds crazy to ignore reality and only hear what you want to hear. But markets work that way for a good reason: they embrace the new, not what they were already prepared for. And by definition, when investors are bearish, they expect bad things.
Polls suggest their sentiment has only just improved from very depressed levels over the past month. According to the American Association of Individual Investors, there are still more bears than bulls. Concerned fund managers were holding the highest level of cash since the September 11, 2001 attacks, according to a Bank of America survey earlier this month, and were even less willing to take risks than they were after the collapse of Lehman Brothers in 2008.
On the options markets, too, the relative demand for “put” options to protect against falling prices is significantly higher than in the post-pandemic boom, albeit somewhat less extreme than in the previous month. Even Wall Street analysts have struggled to lower earnings forecasts after spending most of the year raising them.
The question is whether investors will remain bullish. Sentiment is still pretty depressed, so it’s possible they’ll find reasons to buy for a while longer. But for the upside – the Nasdaq is up 17% since its mid-June low; the S&P 500 is up 14% – it takes more than just sentiment to stay sustainable. Investors have to be right and the Fed wrong about what the Fed will do next year.
That is possible, as I wrote on Wednesday. There’s a narrow path that would be great for markets, where collapsing global demand and repaired supply chains are bringing inflation down fast, the Fed is timing rate cuts in time to avoid a deep recession, and current worries are only manifesting as a slowdown in the economy Turn out to be mid-cycle.
I still hope that the current technical recession, with two quarters of contracting GDP, doesn’t become a deeper problem, but I’m far from convinced that a timely turnaround by the Fed is the most likely outcome. What I’m pretty sure about is that the recent sentiment-driven rally will end without a soft landing, looking like another dead cat destined to hit the earth.
Write to James Mackintosh at [email protected]
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