Market participants admit to their confusion about where the market is heading. On one hand there are many concerns suggesting that this is not the time to buy stocks, and on the other the market is not far from its highest levels in a year. The list of worries is not trivial: banking crisis, yield curve inversion, tight monetary policy and a possible, first-ever U.S. default. Investors are wondering why the market is not succumbing to these worries.
The answer may be simply that there is just too much money flowing around. New research shows that there is still a good chunk left in savings from the pandemic injections – and the Fed does not seem very aggressive at bringing down money supply. This cash has to be deployed somewhere, and although much of it went to T-bills and money market funds, it also makes it easy for investors to keep their stocks, especially because they have brought down their exposure. As long as this is the case, and barring a serious disruption, downside for stock prices may be limited.
This buys time to work through a long list of issues, which makes it more likely that the next market direction will be up. As a colleague pointed out, a strong rally would be the “pain trade” for many investors, because they are underexposed and they will miss it, at least in its initial stages. And the money that is now on the sidelines could provide a lot of fuel for the next bull market.
The wall of worry
There is no question that the market is worrying about serious issues, and a banking system in peril is close to the top. Some doubt that it is very widespread, insisting that the bank failures so far are due to specific missteps by bank management. This may be true, but it doesn’t explain why the entire regional bank sector is still 40% below where it was before the Silicon Valley Bank failure. Certainly nobody thinks that the whole sector is led by incompetent managers. Rather, the fear is that a systemic problem may be lurking in the shadows.
Another worry comes from the inversion between 10-year U.S. Treasury rates and 2-year and 3-month rates, now at its deepest in several decades. This has long been associated with an upcoming recession. In fact, the Chicago Fed argues convincingly that is the 3-month to 10-year rate difference is the most accurate predictor of recessions. A paper by the Federal Reserve Bank of San Francisco (FRBSF) adds that this measure is best at forecasting recessions when initial jobless claims start to climb and both housing starts and the ratio of job vacancies to unemployment start to fall. All such conditions are present today.
The Fed is, of course, the market boogeyman, insofar as it has not wavered from its war against inflation. Some argue that because most headline inflation numbers have declined, further action is unnecessary and will damage to the economy. The Fed, on the other hand, rightly points out that service inflation is stuck at high levels, and a few Fed officials are even hinting that more rate hikes are possible.
The worst fear of all is a U.S. debt default, of course. This would be so catastrophic that the market tends to dismiss it, partly because it would be so absurdly unnecessary and catastrophic, and partly because it has heard the story before and it never came true. The market’s conclusion is that it is just a lot of crying wolf, but in the fable, of course, the wolf eventually shows up. The presence of some new members of Congress who seem intent on burning it all down surely increases the likelihood of a miscalculation, if not now then maybe in the not-too-distant future.
The wall of money
So with all those concerns, how come the market is not much lower?
One reason is the “the market” tends to mean “the S&P 500,” which obscures what is really happening with stocks. While the index has gone up just over 9% this year, the ten largest stocks (representing 27% of market capitalization but only 2% of the 500 stocks) actually gained 44% in 2023, which means that the remaining 490 stocks declined by 4%. Which in turn means that a portfolio containing 98% of all stocks in the index (all but the top 10) would have underperformed the index by 13%. This suggests that most stocks have, in fact, reacted to the concerns. However, it’s still not clear why the market as a whole (including all stocks) is still positive for the year.
One reason may be that the companies behind the top 10 stocks have virtually no need for cash, as they hoard cash themselves. Because they don’t really need external financing, tighter financial conditions or banking system problems have little direct impact. The list includes Apple
Another, possibly more important reason, is that there is a lot of money still sloshing around from the pandemic days. According to a recent paper from the Federal Reserve Bank of San Francisco (FRBSF), consumers still have $500 billion of excess savings remaining from pandemic-related injections “available to support personal spending at least into the fourth quarter of 2023.”
As a result, there is still a lot of liquidity in the economy which the Fed has shown no urgency to bring down. This is not surprising, because drying up liquidity is tricky, especially because the failure of regional banks required emergency injections of more than $300 billion. With the sector under the microscope, the financial system can quickly be caught in a crisis at the first whiff of a bank having cash problems. This may explain why the Fed has been so aggressive with rates, since they are a safer tool. But it prevents the Fed from extracting liquidity freely just when it wants to tighten policy.
It’s true that bank deposits recently fell, but the decline most likely reflects a shift out of banks and into higher-yielding T-bills and money market funds. Consumers still have plenty of cash to spend (if much of the excess savings are in the middle-income tiers) or to keep their money in the market (if they are in the upper-income tiers).
Either way, the additional savings could mean that a recession could be pushed into the future, long enough for inflation to be brought down to the Fed’s comfort level. If bank concerns recede and a default is avoided, the broader market may already have a strong base from which to rally. For many, that will be the pain trade.
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