The current bull market in stocks looks sustainable as long as the Federal Reserve doesn’t mess things up.
Ned Davis Research said on Wednesday that a Fed-induced recession is the most likely risk that could derail stocks.
“If the Fed panics and cuts rates, a blow-off bubble peak would be possible,” NDR said.
A policy mistake from the Federal Reserve is the biggest risk that could cut short the current bull market in stocks, according to a Wednesday note from Ned Davis Research.
The firm highlighted that the S&P 500’s 25% rally from its mid-October low has all the hallmarks of a long-term secular bull market rather than a short-term cyclical bull market. But that can change pretty quickly if the Fed misfires on its interest rate policy.
“Short cyclical bulls tend to occur during secular bear markets and coming out of recessions. Neither describe the current backdrop. Brief bulls have also been caused by extraordinary events like an inflation resurgence or bubble blow-off top. This cycle’s catalyst is more likely to be a Fed-induced recession,” NDR said.
The firm said what’s helping sustain the current bull rally is the fact that stocks have been in a secular bull market since 2009, and while it might be closer to the end than the beginning, it’s too soon to say that a secular bear market has begun.
“The secular backdrop does not support the brief cyclical bull case,” NDR said.
Additionally, the resilient economy since the COVID-19 pandemic means that 2022’s bear market decline in stocks occurred absent a recession. That fact favors the idea that the current bull market in stocks is more secular in nature than cyclical, according to the note.
As a result, the Fed represents the biggest risk to the stock market, which is the case whether the Fed cuts or continues to raise interest rates.
Highlighting an example of how a policy mistake can come regardless of the direction of rates, NDR pointed out that the implosion of Long-Term Capital Management in 1998 sparked a brief bear market in stocks and led Fed Chairman Alan Greenspan to cut interest rates three times. Stocks took off after that, leading to a bubble.
“The current surge in FANMAG and AI stocks has not been nearly as great as [technology, media, and telecom] stocks in 1999. But if the Fed panics and cuts rates, a blow-off bubble peak would be possible,” NDR said.
On the flip side, if inflation lingers and Fed Chairman Jerome Powell aggressively hikes interest rates again, he could plunge the economy into a recession and effectively end the bull market.
“A Volcker-type early 1980s recession would seem more likely than a Burns/Miller policy mistake, but an external shock could trigger a resurgence in inflation beyond the Fed’s control,” NDR said.
Ultimately, a lot has to go right for the bull market to be sustainable and long-lasting, and much of that hinges on the Fed finding the sweet spot for interest rates that enables continued economic growth but also keeps inflation at bay.
With interest rates sitting at more than 5%, all eyes will be on the Fed’s next interest rate decision at its July FOMC meeting.
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