Remarkable surge in stocks lately: risky scenario or authentic market rebound?

Currently, stocks are witnessing an extraordinary surge, propelling the S&P 500 into overbought territory for the first time since August 2022. This upward trajectory deviates from underlying fundamentals as the stock market factors in a substantial economic recovery. In this article, we will explore the reasons behind this phenomenon, the potential hazards it poses, and the choices available to investors in such a climate.

it is crucial to acknowledge the market’s current overbought condition. By examining the Relative Strength Index (RSI), we can observe that overbought readings have historically coincided with significant market peaks, eg. as was the case in August 2022 and November 2021. During these periods, the overall macroeconomic landscape deteriorated, leading to market corrections. However, during bull runs, prolonged overbought readings only triggered minor corrections before the market resumed its upward trajectory. Therefore, knowing whether the ongoing market recovery is sustainable is the key to making good trading decisions.

To know whether the current market rally signifies a genuine economic recovery, we need to look into the relationship between economic activity and the stock market. Typically, these two factors move in tandem. However, at present, a stark contrast emerges between the stock market’s ascent and the sluggish state of economic activity, as depicted by Purchasing Managers’ Index (PMI) data. Currently, the market is most likely pricing in a reversal in PMIs and a substantial resurgence in economic activity.

To gain a broader perspective, let’s reflect on June 17th, 2022, when the market hit rock bottom. At that time, the S&P 500 was experiencing a significant decline, marked by a negative 20-year-over-year change. At this time, shortly after, the market had excessively priced in negative news, creating an enticing risk-reward ratio for investors seeking potential upside in equities. This historical context sheds light on the current situation, where the market has already priced in substantial positive news, potentially influencing future returns.

Examining historical patterns can offer valuable insights into similar market scenarios. For example, in 2012, the market priced in an economic recovery while PMIs were on a downward trend. Investors successfully anticipated the subsequent economic upturn, leading to a minor correction followed by sustained market growth. However, investing during an optimistic climb may not always yield favorable outcomes, as evidenced by the subsequent period of market stagnation.

The optimistic take on the current economic recovery is supported by a low unemployment rate. A declining unemployment rate typically indicates economic growth, facilitating cyclical upturns in PMIs. This correlation was evident between 2010 and 2018 when a strengthening labor market triggered cyclical recoveries and subsequent bull runs in the stock market.

However, a counter argument arises from the significantly inverted yield curve, indicating a hawkish monetary policy and potential economic challenges. Historically, when the yield curve inverts, unemployment reaches its lowest point and begins to rise, causing PMIs to decline. This trend was observed in 1989, 2000, and 2008, suggesting that the current yield curve inversion could signal a slowdown rather than a robust economic environment. Examining the yield curve’s shape provides insights into the potential trajectory of PMIs and economic activity in the coming months.

Although the rally indicates a significant economic recovery, caution is needed due to the market’s overbought state and the disparity with underlying fundamentals. True market recoveries rely on synchronized improvements in economic activity and the stock market, a relationship currently lacking.

Information presented in this article is for educational purposes only and should not be considered financial advice. Before making any investment decisions, conduct thorough research and consult with a qualified financial advisor.

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