(Bloomberg) – As tempting as it is to attribute the stock market’s meteoric rise to expectations that the economy will prosper despite war and inflation, other forces are at work in the rally.
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How much they are responsible for is a serious question for traders and central bank modellers.
Down just three times in two weeks, the S&P 500 has now climbed 11% since mid-March to post one of its strongest gains over comparable periods in the past decade. The rebound, defying bond market recession alarms, recovered nearly three-quarters of its January and February losses.
Before assigning an economic narrative to the rebound, it’s worth considering some of the constituencies that helped fuel it. These include pension funds that buy stocks at the end of the quarter, computer traders programmed to add stocks when volatility plunges, and short sellers forced to buy back borrowed stocks when prices rise.
Their actions help explain why stocks have continued to rise despite outflows from equity funds, and fuel warnings from some Wall Street analysts that the gains are a bearish rally. Purchases from these groups reflected a need to adapt to market movements, rather than genuine demand driven by improving fundamentals.
“I wonder how sustainable it is – there’s a lot of technical detail,” said Michael Purves, founder of Tallbacken Capital Advisors. “You need to see fundamental investors come in and feel comfortable buying this dip. But to do that, they’ll need to see some stability at the back of the Treasury curve and earnings will need to be good.
With earnings season still two weeks away, investors have few clues as to how corporate America is handling runaway inflation and the Federal Reserve’s first rate hike since 2018. Meanwhile , parts of the Treasury curve inverted, raising concerns that the central bank’s campaign to tame price increases could push the economy into a recession.
All the uncertainty generated by the Fed and the war in Ukraine sent the S&P 500 up 13% from its all-time high in mid-March. At that time, JPMorgan Chase & Co. predicted that pension funds and sovereign wealth funds would have to replenish their holdings of plummeting stocks, with a potential buying spree totaling $230 billion.
It is difficult to determine whether the ensuing rally was helped by an actual rebalancing of repos or whether other investors bought stocks in anticipation of it. Either way, the move was powerful. The S&P 500 jumped 11% and recovered major trendlines such as its 200-day moving average. The Cboe Volatility Index plunged to its lowest level in more than two months.
In some ways, the rally has started a cycle that pushes macro-systemic strategies to take charge of equities. These funds, using momentum and volatility signals to guide trades, had spent previous months betting against the market.
In the week to Monday, quantitative funds, including funds targeting volatility and trend-tracking commodity trading advisers, bought $25 billion worth of equity futures, according to an estimate of Charlie McElligott, multi-asset strategist at Nomura Holdings.
A similar dynamic played out at the individual stock level. Highly-rated stocks, targeted by short sellers during the rout earlier this year, outpace the market on the upside as bears capitulated.
A Goldman Sachs Group Inc. basket of best-selling companies has jumped 27% since its March low, more than double the gain of the S&P 500 over the period.
“Leveraged investors participated in the current selloff by aggressively reducing their equity exposure,” Goldman strategists led by David Kostin wrote in a note. “The short coverage of these participants helps explain why some of the most durable stocks have recently risen sharply in the face of rising interest rates and a more hawkish Fed.”
While the rally may have emboldened some buyers, it has yet to lift animal spirits in general. Even as stocks rally to all-time highs, sentiment is stuck at even more depressed levels than during the dark days of the pandemic, according to Goldman’s stock sentiment indicator that tracks everything from selling activity retail to cash flows and fund positioning.
From a maverick’s perspective, lack of confidence means potential buying power, and the only missing ingredient is some kind of catalyst to convince skeptics that the bull market will survive.
What that catalyst might be is up for debate, though one argument gaining traction is that equities can function as an inflation hedge. Indeed, analyst estimates have remained firm during this year’s turmoil, a clear sign of corporate resilience.
How much investors are willing to pay for those profits is the main variable that will influence the market, according to Dennis DeBusschere, the founder of 22V Research. He points to a wild swing in price-earnings multiples as the culprit for this year’s market chaos. With borrowing costs set to rise in coming years, he sees a ceiling in stock valuations.
At 20 times earnings, the S&P 500 was trading at a high ratio that, before the 2020 pandemic, had only happened once in the past two decades – the dot-com era.
“Be skeptical about the continuation of the latest story,” DeBusschere said. “Financial conditions are likely to tighten and are a headwind for the P/E, limiting the upside.”
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