Immaculate Disinflation Sparks Market Rally
Last week, all three major indexes experienced another week of gains, with the S&P 500 up over 17% by Friday's close. The Nasdaq has seen an even more impressive rise, doubling that of the S&P 500. Investors were encouraged by various data points that indicated a cooling inflation both in the U.S. and abroad. This positive news, along with a decline in jobless claims and some early wins in the earnings season, fueled hopes that the Federal Reserve may ease its monetary tightening efforts without causing significant economic damage.
While pessimists have expressed concern that persistently high inflation would lead to the Fed raising interest rates and driving the economy towards a hard landing, last week's readings suggest otherwise. The data indicates a decline in inflation alongside stable economic growth—a scenario often referred to as a "goldilocks" scenario or Immaculate Disinflation, as described by Sevens Reports' founder Tom Essaye.
The confirmation that inflation is slowing down without negatively impacting employment is undoubtedly good news. It has also allowed stocks beyond the usual Big Tech favorites to experience an increase in bullish sentiment. However, as Essaye points out, last week's reports did not introduce a new positive catalyst for the market but rather reinforced what was already widely assumed.
As a result, for the market to continue its rally in what has already been a remarkable year for gains, fresh bullish signals will be needed.
Market Outlook: Finding Opportunities in a Positive Environment
As we assess the current market landscape, there are three key factors that could influence its direction, according to Essaye. These include a significant decline in Treasury yields, stronger-than-expected corporate earnings, and a renewed wave of artificial-intelligence optimism.
Both declining Treasury yields and impressive corporate earnings have the potential to expand the S&P 500's multiple. This expansion would provide more room for the index to experience further growth. Moreover, the surge in AI enthusiasm played a crucial role in pulling stocks out of a slump fueled by regional banks in March. As a result, this optimism surrounding artificial intelligence could potentially lead the market higher, even at rich valuations.
It is important to recognize that the S&P 500 is currently reflecting three positive factors: no hard landing, falling inflation, and the expectation that the Federal Reserve will hold off on raising rates for an extended period, with the possibility of rate cuts in the near future. Considering these factors, it can be concluded that the gains in the stock market are legitimate. However, it is likely that they may be exhausted in the near term. Therefore, it would require an additional catalyst to propel stocks to higher levels.
Although the current economic environment appears relatively benign, investors must not drop their guard. Historically, recessions tend to materialize once the Federal Reserve halts rate hikes. In addition, while cooling inflation is generally positive news, it may still exert downward pressure on corporate profits in the present quarter.
Assuming "Goldilocks" conditions prevail, Essaye suggests that investors concentrate their investments on cyclical sectors of the market that have yet to catch up with the broader market. These sectors are expected to benefit in the long run from what he refers to as "Immaculate Disinflation." Specifically, he recommends considering investment opportunities in the Industrial Select Sector SPDR exchange-traded ETF (XLI), the Materials Select Sector SPDR ETF (XLB), the Energy Select Sector SPDR ETF (XLE), and the Financial Select Sector SPDR ETF (XLF).
Expanding Market Gains: Stragglers Catching Up
In recent times, market gains have not been limited to just Big Tech. Other sectors, which have been lagging behind, are now expected to make up lost ground. With favorable conditions supporting them, these sectors are poised for a potential rebound. This promising outlook is reminiscent of the astonishing rally witnessed in 2023, which has defied expectations.
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