Why Stocks Are Now Rallying

Stocks rebounded strongly in July despite continued Fed tightening and weak economic data. The S&P 500 jumped by 9.1%, its biggest monthly gain since 2020, and the Nasdaq 100 rallied by 12.6%. Instead of economic data or earnings, a conviction that the Fed is winning against inflation, and will soon end its tightening, drives the rally, in my view – see the rationale below.

Our 6-month outlook for the S&P 500 increased to 7.4% from 6.4% on June 30th, despite higher market valuation after the July rally. The June-30th maximum-bullish signal by our models turned out to be very accurate, and our bullish stance continues.

Economic data went from bad to worse in July, and Q2-2022 corporate earnings were generally weak. In addition, the Fed delivered the second 75-basis-point rate hike in July. So, why did stocks rally so strongly? Bear with me to the end of this article for rationale.

The Fed hiked its Funds rate by 0.75% again in July, to 2.5%. Apart from a few months in 2019, the rate is now at its highest since 2008:

The US economy slowed markedly in recent months. This can be seen by the ISM Manufacturing PMI: it fell to around 53 in June and July, pointing to the slowest growth in manufacturing since June of 2020. The level of 50 separates growth from contraction.

Consumer sentiment remains near record low, due primarily to inflation concerns. The University of Michigan’s sentiment index rebounded just slightly, to 51.5 in July from a record low of 50 in June:

It appears that the Fed’s tightening is beginning to “work.” In addition to economic slowdown, it broke the bull market in commodity prices. Nearly all commodities began to fall. For example, the WTI crude oil fell below $95 per barrel form its $120 peak in June:

Copper, wheat and some other commodities experienced even sharper declines:

Inflation continued to rise in June, to 9%, a new 41-year high. However, we should understand that inflation rate is backward-looking: it measures the rate of price change compared to a year ago. In addition, it’s reported by the BLS with one-month lag. Inflation has been largely driven by energy and other commodities, and as described above, commodity prices have now begun to fall. This suggests, other things equal, that inflation should begin to ease in a month or two.

Is the Fed nearly done with tightening? Bond investors seem to have already priced-in this scenario – the 10-year Treasury yield fell to 2.63% on August 2nd from its recent peak of 3.5%:

Investors watched how the Fed, determined to control rising inflation, drove the market decline in the first half of 2022. Always forward-looking, they now focus on what the Fed will do next. Commodities and bond markets signal, correctly or not, that the Fed has won the fight against inflation, and will soon end its tightening. It appears that stock investors imagine that with the Fed out of the way, a bull market will resume. They see a reversal of 1H-2022 and are rushing to buy stocks.

Model Capital Management LLC (“MCM”) is an independent SEC-registered investment adviser, and is based in Waltham, Massachusetts. Utilizing its fundamental, forward-looking approach to asset allocation, MCM provides asset management services aimed to help other advisors implement its dynamic investment strategies designed to reduce significant downside risk. MCM is available to advisors on SMArtX Advisory and Envestnet platforms, but is not affiliated with those firms.

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