(Seth Wenig/AP)
The glass is half full on Wall Street. But should it be?
There's plenty for investors to celebrate right now, but a look under the hood reveals quite a bit of decay.
Here at Before the Bell we're playing the role of Debbie Downer to Wall Street's Pollyanna and breaking down some of the arguments for a continued market rally.
Markets are hot: There's been an optimistic narrative in markets these past few weeks. The S&P 500 just hit a new high for the first time in two years and the Dow crossed the 38,000 level on Monday for the first time ever. In Europe, Germany's Dax traded at an all-time high Wednesday, and the STOXX index is closing in on a new record.
Real bond yields (that's the return on US Treasuries minus inflation) are near six-month lows. And financial conditions are easing as borrowing costs decline, which may help economic growth.
But Wall Street's gains are narrow: Major indexes are up, but the broad market isn't.
As of last week, Nvidia and Microsoft accounted for about 75% of the S&P 500's gain this year, according to analysts at Bespoke Investment Group. The 20 largest stocks in the index, they found, made up 110% of the index's gains, while the remaining 480 were acting as a drag.
Last year, the S&P 500 rose by just over 24%, but if you were to weigh each stock in the index equally, it gained just 11.6%. That's the largest outperformance by the S&P 500 over its equal-weighted version since the 1998 dot-com bubble, said Henry Allen, a strategist at Deutsche Bank, in a note to clients on Tuesday.
A narrow rally doesn't necessarily mean a crash is coming. But it's largely Big Tech that's driving markets higher, and that concentration of gains in so few stocks carries inherent risk. "Those equity gains could prove vulnerable to a change in sentiment towards that group," wrote Allen.
The economy is strong: Economic data has been doggedly resilient over the past few months.
The US unemployment rate is at 3.7% — the Federal Reserve predicted about a year ago that it would be at 4.6% right now. Consumer sentiment in January reached its highest level since July 2021, according to the University of Michigan's consumer sentiment index, and retail sales were up 0.6% in December.
Economists polled by the National Association of Business Economics now overwhelmingly say that the US economy will avoid a recession this year.
On top of that, inflation rates have been broadly easing, and Americans expect that to continue. The University of Michigan found that consumers expect inflation to fall to 2.9% by next year, the lowest since December 2020.
But investors are adjusting expectations: Investors eventually get used to strong data, and come to expect it. Any signal of a weakening economy could send stocks plunging.
"It's hard for data to keep surprising in the same direction, since investors simply adjust their expectations," said Allen.
Rate cuts are likely: Fed officials are expecting and openly discussing interest rate cuts this year. Fed Governor Christopher Waller said just last week that "as long as inflation doesn't rebound and stay elevated, I believe the [Fed] will be able to lower the target range for the federal funds rate this year."
Financial markets currently see a nearly 46% chance the Fed will cut rates by March and about an 85% chance that the Fed will cut rates by May, according to the CME FedWatch Tool.
But Wall Street could be getting ahead of itself: Since the start of the year, investors have pushed back their rate cut timelines, said Allen. Just one month ago, more than 75% of investors thought the central bank would cut rates at their March meeting.
That's partially because a strong economy and geopolitical strife could force the Fed to perform an about-face soon after starting to cut rates.
AI might save us: The boom in artificial intelligence has been a main driver of the recent rally in equities. And the budding industry could increase productivity in the years to come.
"In the next few years, the main impact of AI on work will be to help people do their jobs more efficiently. That will be true whether they work in a factory or in an office," Microsoft founder Bill Gates wrote in a blog post last year.
"AI has huge potential to increase productivity," BlackRock CEO Larry Fink said at his firm's last investor day. "It may be the technology that can bring down inflation."
But it could kill jobs: But the tech sector kicked off the new year with a spate of fresh job cuts that are coming at the same time as the industry is doubling down on investments into artificial intelligence.
The continued labor upheaval unfolding in the very industry creating AI may be an omen as the technology reshapes the broader business landscape in the years ahead.
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