The big stock market rally on Tuesday is likely to fizzle out: capital economics

It was turnaround Tuesday for the stock market as investors returned from a three-day weekend after the S&P 500’s worst weekly plunge since 2020. Skeptics see a bear market rally likely to fizzle.

“In spite of [Tuesday’s] more than 2% gain in the S&P 500 SPX,
…we doubt we’ve bottomed the index as we believe the Fed’s tightening cycle is far from over and the US economy will weaken,” said Oliver Allen, market economist at Capital Economics, in a statement .

The Dow Jones Industrial Average DJIA,
ended Tuesday more than 640 points higher, up 2.2%, while the S&P 500 rose 2.5% and the Nasdaq Composite COMP,
up 2.5%.

Allen named three criteria that could create the conditions for a bottom on the stock markets.

The first would be a major shift in monetary policy expectations as the Federal Reserve shifts to supporting the economy and financial markets.

The second would be signs that the business cycle is beginning to turn. Allen said the company’s analysis of the S&P 500’s performance in the context of post-war U.S. recessions suggests that the bottom in the U.S. stock market almost always came after a recession began and often not long before it ended — with the notable exception from the prolonged bear market that followed the bursting of the dot-com bubble.

See: Equity markets are not fully pricing in a looming recession, Morgan Stanley’s Mike Wilson warns

And the third, the economist said, would deflate US stock market valuations enough for stocks to look sufficiently attractive to investors again after a period of surplus.

On that last point, Capital Economics doesn’t think the S&P 500’s valuation is particularly high given historically low US Treasury yields, Allen said, meaning the S&P 500 shouldn’t fall any further on the economic and monetary backdrop for stocks becomes cheaper.

However, investors may wait a while for this change in backdrop.

“We expect fed funds rates to peak at around 4% early next year and stay there for some time. Additionally, our revised, higher US Fed Funds interest rate forecasts have led us to become slightly more bearish on the US economy,” Allen wrote.

Capital Economics, while not anticipating a recession, expects a period of weak economic growth as tightening monetary policy dampens demand and weighs on corporate earnings, he said.

“Against this backdrop, we doubt the fortunes of the S&P 500 will take a significant turn anytime soon. We now suspect the index will bottom towards the end of next year,” Allen wrote. The big stock market rally on Tuesday is likely to fizzle out: capital economics

Brian Lowry

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