U.S. stocks shot up nearly 30% in 5 months. Is it time to worry about a correction?

By Joy Wiltermuth

Stocks are on a steady path higher since the October lows, despite interest rates near a quarter-century high and inflation above target

Investors no longer seem worried about the Federal Reserve keeping interest rates "higher for longer," despite a strong run up in equities and other risky assets since autumn.

The major U.S. stock indexes posted their biggest weekly gains in months on Friday, days after Fed Chairman Powell kept three rate cuts on the table for this year, but spelled out a cautious path out of restrictive monetary policy territory.

Big equity gauges recently booked record new highs, while the S&P 500 index SPX now sits about 27% above its Oct. 27 low, according to FactSet data.

"It's been a lot," said Iman Brivanlou, head of income equities at TCW, a Los Angeles-headquartered investment firm, about the rapid rise in stocks.

While he credits the Fed for whittling inflation down without causing much damage to the economy, he also worries stocks have gone up too far, too quickly.

"To be fair and balanced, there's a lot to be happy about," Brivanlou said. Yet while others are "super excited about having a bunch of rate cuts," he sees red flags. "It can't be that inflation stays near 3% and the Fed cuts rates nearly three times, without some kind of issue."

Upheaval in credit markets, financial instability or simply inflation that persists could be among the issues he foresees. "What the market is banking on today, it is likely going to have to give back," Brivanlou said.

Betting on 'perfect'

The swift rally on Wall Street comes while the Fed's policy interest rate sits among the loftiest levels of a quarter-century.

The Fed now sees its policy rate falling to 4.6% this year from a current 5.25% to 5.5% range, with a gradual path to 2.6% in 2026, all while avoiding recession and high unemployment. Putting the numbers aside, it would mean Powell pulls off a "soft" landing for the economy.

"We have to remind ourselves it's still a restrictive environment," said Adam Abbas, head of fixed income at Harris Associates, Oakmark Funds. "You have to be careful in assuming this is a perfect landing."

Like the major equity indexes, credit spreads in the U.S. bond market have also rallied sharply, leaving investors with threadbare compensation.

While higher Treasury yields help with overall yields, Abbas pointed to spreads on BB rated high-yield "junk bonds" JNK that have fallen below 190 basis points above risk-free Treasury BX:TMUBMUSD10Y rates, down from 300 basis points in October.

The drop comes despite the potential for higher oil prices, (CL00) greater commercial real estate RWR fallout than anticipated, a looming default cycle in leveraged loans and other risks.

"You need to think about your downsides more carefully, if something were to go wrong," Abbas said.

For the same reason, Brivanlou at TCW likes companies with strong balance sheets and equity exposure in select real-estate investment trusts that are secondary plays to the artificial intelligence mania, including cellphone towers and data centers.

"We are positioning to capitalize on longer-term trends," he said, adding that TCW has been underweight office, retail and other trouble areas for the past five years.

Can't build fast enough

A resilient U.S. economy, hopes for interest rate cuts and the craze in artificial intelligence stocks have fueled the market rally.

This comes despite the "last mile" of inflation looking hard to overcome and recent surprises in economic data being less of a catalyst for selloffs.

The past five years saw the S&P 500 index book 21 declines of 5% or more and five corrections of at least 10%, according to Dow Jones Market Data. This year has seen zero in either category.

"It's higher for longer, and stronger for longer," said Michael Skordeles, head of U.S. economics at Truist Advisory Services.

While he sees some "fantasy" being baked into earnings growth expectations, he also says it isn't like in the early 2000s when technology companies with no earnings fueled the dot-com bubble.

"It's a little frothy, here and there, but there is some justification in that there are real earnings," Skordeles said. He also sees the $45.5 trillion U.S. housing market's role in stabilizing the economy.

"The house-hostage situation, it's still very much in place - and going to be in place for several more years," Skordeles said of existing homeowners who don't want to give up low mortgage rates.

"We've been under-built for the better part of 15 years and that isn't going to be resolved over night," he said.

But while driving from an economic summit in Miami, he also talked of construction cranes that still dot the city's skyline, even as jitters grow about overbuilding, especially in the multifamily sector, in some Sunbelt states.

Existing homeowners appear likely to sit tight, avoiding today's near 7% mortgage rates, he said. But for builders ITB XHB offering borrowers few concessions other than a break on mortgage rates on a new home, it's been an entirely different story.

"They can't build them fast enough," Skordeles said of new homes, which "isn't a recessionary sign."

PCE on deck

The Dow Jones Industrial Average DJIA ended up 2% for the week, snapping three weeks of decline. The S&P 500 close 2.3% higher for the week, while the Nasdaq Composite Index COMP rose 2.9%, including posting a record finish Friday.

The week ahead brings more housing data, with new home sales on Monday, the S&P Case-Shiller home price index on Tuesday and pending home sales Thursday, and consumer data sprinkled in between.

The big economic item will be Friday's PCE price index, the Fed's preferred inflation gauge. Fed Chairman Jerome Powell said last Wednesday that the index is expected to creep up to 2.5% in February, but stay at 2.8% on a yearly basis. The central bank wants to see 2% annual inflation.

-Joy Wiltermuth

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03-24-24 1201ET

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