The stock market has experienced a significant rally this week, and it's not just limited to Big Tech companies. While investors are hopeful for a strong finish to the year, there are still obstacles to overcome.

A Truer Gauge of Performance: The Invesco S&P 500 Equal Weight ETF

Since late October, the Invesco S&P 500 Equal Weight exchange-traded fund has seen a remarkable surge of 17%. This ETF provides an equal weight to each stock in the index, offering a more accurate representation of the average stock's performance in the S&P 500.

Decelerating Pace of Inflation Drives Gains

The primary driver behind these gains is the slowdown in inflation, which has convinced the Federal Reserve to hold off on further interest-rate hikes during its past two meetings. In fact, the central bank recently hinted that it might even consider cutting interest rates in 2024. This accommodative stance allows the economy to continue growing and supports the increasing sales and profits of companies. Additionally, lower rates elevate the value of future profits and dividends, leading to higher valuations for various companies, ranging from high-dividend payers to high-growth technology firms.

Sustaining the Rally: Encouraging Signs

Fortunately, there are positive signs that indicate the market has a solid chance of maintaining its rally. After Fed chair Jerome Powell's speech, stocks surged higher on Wednesday and continued to close in the green on Thursday, despite the absence of significant news regarding rates and the economy. This "follow through" for stocks suggests that traders and investors are confident in buying shares, as they anticipate future profits driving share prices upwards in the long run.

According to Frank Cappelleri from Cappthesis, this "upside follow through" is crucial for further gains and he foresees more positive outcomes for the standard, market value-weighted S&P 500.

The Risk of a Market Decline: No Guarantees in Stock Investing

While there is potential for explosive market gains, it's important to remember that nothing is guaranteed in stock investing. In the near-term, factors such as uncertain economic conditions and unforeseen events increase the risk of a market decline.

Overall, the stock market's rally has encompassed a wide range of companies, driven by the decelerating pace of inflation. Despite potential hurdles, encouraging signs suggest that the market has the potential to sustain its upward trajectory. However, as with any investment, it's essential to remain cautious and acknowledge the inherent risks involved.

Market Vulnerabilities and the Risk of Disappointment

Stocks are currently reflecting a high level of optimism, leaving them vulnerable to potential disappointments. The equal-weighted S&P 500, which is trading at 16 times expected per-share earnings for the next 12 months, has seen a strong increase since the start of the October rally when it was just below 14 times. Although this valuation is lower than the standard index's 19.4 times, it is by no means cheap. Additionally, it is noteworthy that the equal-weighted index has rarely traded above the standard one in the last decade, according to FactSet.

This situation implies that any underwhelming financial results could easily lead to a decline in stocks. Currently, analysts expect aggregate sales on the equal-weighted index to grow by 3.8% in 2024. They also anticipate improved profit margins due to moderating employee compensation and product costs. Furthermore, increased stock buybacks would contribute to higher per-share earnings, with a consensus forecast of 8% bottom-line growth in 2024. However, these profit projections heavily rely on sustained economic growth.

John Lynch, chief investment officer at Comerica Wealth Management, is skeptical about the consensus logic suggesting a 12% profit growth and warns of an impending market drop.

Moreover, if disappointing earnings are not enough to dampen the stock market's enthusiasm, the Federal Reserve (Fed) could also pose a threat. Although markets are currently expecting interest-rate cuts next year, the rate of inflation remains above the Fed's 2% target, standing at 3.1% on an annual basis in November. Failure to swiftly moderate consumer price increases may lower investor expectations for the number of anticipated rate cuts, potentially causing stocks to reverse some of their recent gains.

Charlie Ripley, senior investment strategist for Allianz Investment Management, advises caution regarding the pace and timing of rate cuts to prevent getting ahead of the market.

While the recent rally and evolving rate outlooks provide cause for celebration during this time of year, it is important not to indulge excessively in stocks at the moment. Save that enthusiasm for the holiday dinners that lie ahead.