Why investors shouldn’t be fooled by the latest market rebound

Lisa Shalett

Chief Investment Officer, Morgan Stanley Wealth Management


Summary: Many pundits are bullish on stocks, but there may be evidence that investors need to prepare for a less rosy scenario.

Image of a yellow rain boots.

Three key takeaways

  • The latest rebound in stocks reflects the bullish notion that the interest rate-hike cycle is over and corporate profit growth lies ahead.
  • However, risks of slowing economic growth along with persistent inflation could remain.
  • Investors may choose to look at defensive opportunities, such as utilities and staples, and value plays in financials, US small- and mid-cap stocks, and international equities.

After recently tumbling into “correction” territory, US equities staged a strong rebound earlier this month, accompanied by a pullback in bond yields. Investors, it seems, may be looking forward to continued gains from here on, hoping to end the year with a “Santa Claus rally.”

But what’s behind this latest bounce-back in stocks? It looks like the market zeroed in on the fact that the Federal Reserve left interest rates unchanged in its November meeting, keeping the target federal funds rate between 5.25% and 5.50%. With that, bullish investors were quick to return to the narrative that the rate-hiking cycle is now over, the inflation fight is won, and growth in corporate profits lies ahead. Illustrating this point: The futures market is again pricing a whole percentage point of rate cuts in 2024.

The GIC, however, is less convinced and thinks that there is still a lot of noise in the short term.

What could this mean for investors?

The GIC believes it’s important to base market analysis not just on moves at the index level, like that of the S&P 500, but on what’s beneath the surface and across asset classes.

In light of potentially persistent inflation and slower economic growth—and keeping in mind that individual investors’ circumstances will vary based on their goals and risk tolerance—the GIC believes there are several options, for example:

  • Using market volatility to execute tax-management strategies like tax-loss harvesting.
  • Rebalancing portfolios toward investments that offer strong yields, like stocks with high cash flows that are fairly priced based on achievable earnings targets.
  • Adding “Defensives” to portfolios, such as:

Four reasons to consider remaining cautious

The GIC’s cautionary stance comes from four main observations:

  • Potential slowing in economic growth: Despite blowout readings for third-quarter gross domestic product (GDP), other data suggest a softening in economic activity. Manufacturing weakened sharply in October, according to the Institute for Supply Management’s index, and recent labor market data showed fewer jobs created in October than estimated alongside an uptick in the unemployment rate to 3.9%.
  • A specter of “sticky” inflation: There’s been little improvement in certain key components of inflation, including wages and housing. October jobs data showed wage gains are still running at a higher-than-expected 4.1% year-over-year. Housing prices gained further momentum, gaining an annualized 2.6% in August.1
  • A “sideways” stock market: Even with recent gains in equities, the overall direction in stock prices remains uninspiring. Meanwhile, cyclical sectors such as consumer discretionary goods such as luxury, vehicles and fast food have underperformed their ‘defensive’ counterparts such as utilities. Gold’s continued outperformance also suggests that we are still in a bear market.
  • Cracks in credit: Lastly, stresses are emerging in the weakest parts of high-yield credit. Data show a growing number of bankruptcy filings and weaker financing availability for small and medium-sized businesses, indicating the lagged effects of policy tightening may now be surfacing.

The bottom line

The market’s recent rebound has some bullish investors believing that the interest rate-hike cycle is over and that company profits will grow from here on. But the GIC thinks that risks of slowing economic growth along with persistent inflation could remain.

The GIC believes investors can consider several options in this environment, including, for example, using market volatility to execute tax management strategies, rebalancing their portfolios toward investments offering stronger yields, and adding defensive and value-oriented stocks

The source of this article, Don’t Be Fooled by the Latest Market Rebound, was originally published on November 8, 2023.

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