Despite a temporary bounce fueled by falling rates and a weakened dollar, the S&P 500 (SPX) is likely to experience a fade in its bear market rally. Economic data throughout the week supports the continuation of a pullback, with the index potentially dropping back to 4,100 over the next few months.
The market rally from March to July may resemble one of the most significant bull traps since the 2000 surge of the Nasdaq 100. The trap is driven by the illusion of inflation diminishing, leading the Fed to ease monetary policy. However, the strong and resilient economy is far from convincing the Fed to change its restrictive monetary policy path.
The stock market seems to interpret bad news as good news, expecting the Fed to intervene at any signs of slowing growth. Recent weak PMI and job opening data caused nominal rates to decline. However, stabilizing rates and positive economic indicators suggest that rates will continue to rise. Economic models indicate that real GDP estimates for Q3 have hardly changed despite the data onslaught.
Impact of the Dollar
The stronger-than-expected economic data continues to support the dollar, which has retraced previous losses and could climb further. A strong dollar negatively affects stock prices, reducing competitiveness of US exports and tightening financial conditions. With China’s addition, the balance sheets of major central banks are shrinking, impacting liquidity. Deviation from the usual correlation between liquidity and the S&P 500 is notable.
Falling Into a Trap
Equity investors are misled by recent market moves that imply the worst of the pullback is over. However, the S&P 500’s surge was driven by a weak dollar, falling rates, and the negative gamma regime in the equity market. This rally is likely to reverse in the coming days.
Rising oil prices and increased inflation expectations could complicate matters. If oil prices continue to climb, CPI expectations may rise, leading to the need for higher rates and potential intervention from the Fed. The stock market rally has primarily relied on multiple expansion rather than improving fundamentals. If the PE ratio contracts, the index could return to lower trading levels.
A stronger dollar, higher rates, and rising oil prices will present challenges for the stock market. This could result in a revisit to 4,100 or even lower levels, as bulls realize the importance of fundamentals and macro trends.