The Stock Market Is Rallying. 3 Things That Could End the Upturn.

Also last week, the
S&P 500
hit a new 52-week high, the
Dow Jones Industrial Average
notched its longest winning streak since August 2017, and the
Nasdaq Composite
—the only one of the major three indexes to end the week lower—is still up more than 34% so far in 2023.

All that has left many bears out in the cold, but reality is never simple. An economic downturn may still be on the way. Sevens Report’s founder Tom Essaye sees three areas where problems could still arise.

First, the Federal Reserve has taken interest rates up very quickly, to levels that may be historically low but are still much higher than in recent years. That swift rate-increase campaign was the basis of much pessimism last year, given the potential for a higher cost of capital to have an excessively chilling effect on individual and corporate spending.

The idea that the Fed has gone too far has largely faded as recent data have shown employment and consumer spending are still strong. Yet Essaye notes that the pain of higher rates could still be on the way. Inflation is still far from the Fed’s target of 2%, so rates may remain high for longer than expected. The combination of increased borrowing costs, slowing wage growth, and the continuing impact of inflation is quickly eroding the excess capital Americans built up during the pandemic.

In addition, real interest rates only turned positive recently, giving borrowing costs more potential to derail growth, as inflation readings had been higher than the fed-funds rate, the bank’s target for short-term borrowing costs. “This matters because interest rates are only restrictive on the economy once they are solidly higher than the prevailing inflation rate,” he wrote. “Point being is that rates are only now truly restrictive.”

Then there’s the fact that inflation has been beneficial for some companies, bolstering sales and price increases. Disinflation could also take the wind out of the sails of the labor market, as it has the potential to cut into corporate margins in the coming quarters, leading to calls for layoffs. If that happens along with a pullback in consumer spending as savings dwindle and rates remain high, more companies could turn to cutting staff.

That said, “none of these risks are going to cause a near-term reversal in stocks,” Essaye noted, especially as we keep getting positive data points like those that drove last week’s gains.

In that sense, it does make sense that investors are enjoying the market’s time in the sun. Summer’s lease may have all too short a date, but it doesn’t look likely to run out soon.  

Essaye still recommends buying into cyclical stocks, such as those tracked by the
Industrial Select Sector SPDR exchange-traded fund
(ticker: XLI), the 
Materials Select Sector SPDR ETF
(XLB), the 
Energy Select Sector SPDR ETF
(XLE), and the 
Financial Select Sector SPDR ETF
(XLF).

But remember: Goldman Sachs’s change to its recession forecast, putting the odds at 20%, leaves the probability the bank sees above the post-war average of 15%. Economists surveyed by The Wall Street Journal are getting more optimistic, but still see a 54% chance that a recession will happen in the next 12 months.

Two more caveats: There are ample coming opportunities for the Federal Reserve to assume a more hawkish tone than bulls might like. And the French fry sales indicator—or “fry attachment rate,” which tracks how often fast-food customers add a side of fries as a proxy for economic confidence—is sending mixed messages at the moment.

Let’s hope it doesn’t turn investors’ smiles into a Grimace.

Write to Teresa Rivas at [email protected]