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Stocks have lost ground lately, with the S&P 500 index losing roughly 5% of its value from its recent record peak. Driving this shift in sentiment appears to be a reassessment of Fed policy in the wake of unfavorable inflation readings over the last few months.

This year’s monthly inflation readings appear to show that last year’s favorable momentum has stalled out. While this ‘lack of further progress’, as the latest Fed statement put it, has likely delayed the start of the easing process, market bulls remain sanguine about the Fed and inflation and see nothing egregious with valuations.

Market bears see this optimism in the market as without a solid basis and view the ongoing market weakness as the start of the long-awaited market sell-off. This line of thinking sees inflation as ‘stickier’, leaving the Fed no room to loosen policy any time soon. Valuation worries also figure prominently in the bearish view of the market.

The interplay of these competing views will determine how the market performs in the coming months and quarters. To that end, let’s examine the landscape of bullish and bearish arguments to help you make up your own mind.

Let's talk about the Bull case first.

Inflation & the Fed: The outlook for inflation and what that means for Fed policy is the biggest point of difference between market bulls and bears at this point in time. The bulls see the inflation issue as headed towards a resolution to the central bank’s satisfaction, with the recent run of seemingly unfavorable readings as nothing more than a passing phase reflective of seasonality and measurement issues.

The bulls saw inflation as primarily resulting from pandemic-related factors, with the combination of elevated Covid-driven demand in a number of product and service categories and snarled supply chains showing up in higher prices. These factors were on course to normalize in the post-COVID period anyway, but the Fed’s extraordinary tightening policy sped up the process by moderating demand.

The Fed question on the market’s collective mind is about the timing of the first-rate cut and the number of subsequent cuts. In addition to direct Fed guidance, investors are looking at incoming economic data through the prism of what it tells them about inflation and growth.

Recent signs of stalled progress on the inflation front have forced an evolution of the market’s Fed outlook, with the easing cycle getting underway later than was initially expected. The bulls see this as nothing more than a few months delay in the start of the central bank’s easing policy.

The Economy’s Strong Foundation: As the Q1 GDP report showed, the U.S. economy’s growth trajectory has shifted gears in response to Fed-driven higher interest rates and the runoff in the government’s Covid spending. This is beneficial to the central bank’s inflation fight, particularly the demand-driven part of pricing pressures, notwithstanding the seeming trend reversal in the GDP report’s price deflator reading.

A segment of the market still remains worried about recession risks, but the U.S. economy’s resilient performance in the face of extraordinary Fed tightening has significantly increased the soft-landing odds. Underpinning this view is the rock-solid labor market characterized by strong hiring, a record-low unemployment rate, and steady wage gains. It is hard to envision a recession without joblessness.

The purchasing power of lower-income households has likely been eroded by inflationary pressures, as confirmed by a number of companies on their recent earnings calls. But household balance sheets in the aggregate are in excellent shape, even though most of the Covid savings have largely been used up by now. This combination of labor market strength and steady wage gains should help keep consumer spending in positive territory in the coming quarters.

While estimates for the coming periods have been coming down, the Zacks economic team is projecting below-trend but nevertheless positive GDP growth in 2024.

All in all, the strong pillars of the U.S. economic foundation run contrary to what are typically signs of trouble ahead on the horizon.

Valuation & Earnings: Tied to the economic and interest rate outlook is the question of stock market valuations that still look reasonable given the expected interest rate trajectory.

The S&P 500 index is currently trading at 20.6X forward 12-month earnings estimates, up from 15.6X at the end of September 2022, but down -14.9% from the peak multiple of 24.2X some time back. It is hard to consider this valuation level as excessive or stretched, particularly given the coming Fed easing cycle.

The appropriateness or otherwise of valuation multiples has to be seen in the context of interest rate outlook. Valuation multiples typically expand when the Fed is easing policy, particularly when the catalyst for the loosened policy is confidence on the inflation front instead of growth fears.

Earnings outlook is a key part of the valuation discussion. Contrary to the earlier doom-and-gloom fears, the ongoing 2024 Q1 earnings season is reaffirming the resiliency and stability of the corporate profitability picture, with the growth pace expected to steadily improve in the coming quarters.

What we are seeing this earnings season is that while companies in a number of industries are unable to have adequate visibility in their business, there are many others that continue to drive sales and earnings growth even in this environment. We are seeing many of these leaders from a variety of sectors, including Technology, come out with strong quarterly results and describe trends in their businesses in favorable terms.

Current consensus expectations for this year and next reflect a resumption of strong growth after two years of below-trend profitability growth. In fact, the earnings outlook has started improving lately, with earnings estimates for this year and next starting to go up in recent weeks.

In the absence of a nasty economic downturn, the earnings picture can actually serve as a tailwind for the stock market in an environment of easing Fed policy.

Let's see what the Bears have to say in response.

The Market’s Fed Exuberance: At the start of the year, the consensus view reflected five to six rate cuts in 2024. But this view has shifted markedly after three back-to-back unfavorable inflation readings over the last three months. The expectation at present is for one or two rate cuts this year, with the first cut after the November elections.

The market’s eagerness for Fed easing is at odds with the health of the U.S. economy, which appears to be doing just fine on the back of a tight labor market, keeping stable consumer-spending trends in place. This begs the question as to why the Fed needs to speed up monetary policy easing if there is no imminent threat to the U.S. economy’s growth trajectory.

The Fed restored its credibility on the inflation question through its extraordinary tightening moves, which made up for its initial lethargy in changing course. Given this recent history, it will not be prudent for the central bank to risk its hard-won credibility by prematurely starting to ease policy, which they may have to reverse afterward in case inflation starts misbehaving all over again.

The Valuation Reality Check: Given the bears’ view that the prudent course for the Fed is to be in no hurry to start easing policy in the absence of any issues in the economy, they see no fundamental reason for valuation multiples to expand.

Higher-for-longer interest rates should have a direct impact on the prices of all asset classes, stocks included. Everything else is constant, investors will be using a higher discount rate, a function of interest rates, to value the future cash flows from the companies they want to invest in.

This means lower values for stocks in a higher interest rate environment.

The Earnings Growth Question: Current consensus earnings estimates show +8.6% growth this year and +13.8% growth in 2025, which follows the modest earnings decline in 2023.

Market bears see these earnings growth expectations as inconsistent with the soft-landing outlook for the economy.

Notwithstanding the tough going in the manufacturing sector and the growth implications of the still inverted yield curve, earnings expectations for this year will need to come down significantly to get them in line with the economic ground reality.

Where Do I Stand?

While I acknowledge that the first-rate cut has likely been pushed out, I am skeptical of the higher-for-longer Fed policy view and see this scenario as nothing more than a low-probability event.

The current Fed Funds rate level is almost twice what central bank officials and economists see as the ‘neutral’ policy rate. At the ‘neutral’ policy rate level, Fed policy is neither ‘stimulating’ nor ‘restricting’ economic activities. Even if we account for the ‘lack of further progress’ in addressing the so-called ‘last mile’ in addressing inflation, the central bank has plenty of cushion in its policy arsenal to start easing policy without adversely affecting its inflation fight.

This doesn’t mean that the first rate cut is around the corner, but it does suggest that they don’t need to wait for an extended period to consolidate the inflation gains.

Given this year’s electoral calendar, I would expect the Fed to implement the first rate cut in the post-election November meeting, particularly if inflation readings in the intervening months revert to last year’s favorable trend. In other words, the ‘big disappointment’ is nothing more than a few month's delay in the start of the easing policy.

Regular readers of my earnings commentary know that the earnings picture continues to be resilient, with recent developments on the earnings front showing a favorable turn in the revisions trend. Importantly, positive estimate revisions are spreading beyond the trend’s earlier core in the Tech and Energy sectors to areas like Transportation, Finance, Basic Materials, and others.

The market’s recent weakness and tentativeness reflect a reassessment of the evolving interest rate outlook in light of a delayed onset of the Fed’s easing cycle. The delay of a few months to the first rate cut is a good enough reason to go through this reassessment process. But we remain confident that investors will soon come around to our view of inflation, earnings, and the much more positive times ahead after a short period of volatility.

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