After a rocky few months, stocks have made a strong comeback in the past few weeks. This is thanks to better-than-expected earnings from companies in the second quarter, as well as increasing confidence from investors that inflation in the US has peaked.
However, if you’re thinking this is the start of a new bull market, it’s probably best to wait and see.
Here’s why: The Federal Reserve has two main goals: keeping employment near its maximum level and maintaining stable prices around 2%. With unemployment already at a pre-pandemic low of 3.5%, tamping down the country’s high inflation is the Fed’s top priority. And as the central bank’s emphasized several times lately, it’s willing to do whatever it takes to make that happen.
Although inflation did ease a little in July, it is unlikely to fall significantly unless demand for goods and services decreases significantly.
This is why the Fed is increasing interest rates so aggressively: it is trying to slow down demand by making economic growth more difficult with higher interest rates. In this situation, good news can actually lead to bad news: if the growth outlook improves (usually we would say that this is good news), then inflation is likely to increase again (bad news), which would then force the Fed to raise rates even more (very bad news), until growth slows down enough to reduce inflation.
No one is saying it will be easy to bring down price pressures.
Core inflation, which excludes more volatile food and energy prices, is likely to remain sticky for some time. This is likely to keep inflation from falling to a level where the Fed might comfortably stop hiking.
The Fed’s ability to achieve a “soft landing” – tempering growth to bring inflation down without driving the economy into a deep recession – is far from guaranteed. After all, they’ve only managed it once before.
There’s a good reason for that: a soft landing requires the perfect amount of slowdown, at the perfect time, and monetary policy – the one tool the Fed’s got – isn’t a precision instrument. It’s a blunt tool that may well deliver the wrong amount of stimulus at the wrong time.
To make things even more difficult for the Fed, the effects of interest rate changes are often felt with a delay of several months. It’s like steering a raft into a rapid with only one paddle, facing backward.
To achieve strong stock returns from this point, company profits would need to meet, at the very least, existing expectations. And those expectations are already quite optimistic, with investors seeing earnings increasing by 7-10% over the next two years, profit margins expanding from their already high levels, and inflation dropping as quickly as it soared.
Even if all of that occurs, shares are unlikely to increase as much as one might think, because those high expectations are already factored into today’s stock prices.
On the other hand, if things don’t turn out as well as investors expect, stock prices are likely to fall to reflect the new reality. And remember, losses have a bigger impact on your portfolio than gains. A 100% gain is required to offset a 50% loss, for example, so it might take a while to make up for those losses.
If you are feeling a slight FOMO to buy stocks now, a good way forward could be to see where inflation and growth are heading in the next couple of weeks before committing to the shopping spree.
If the Fed manages to pull off a perfect soft landing, and companies’ profits meet the market’s high expectations, then stocks may continue to soar.
However, if I’m wrong and things do turn sour, then you would miss out on initial gains. But if you’re patient and wait for a market correction, you would be able to buy stocks at much cheaper prices.
There are times for aggression and times for patience. With the current uncertain macro environment and optimistic investor expectations, now may still be a time to wait for better opportunities.