(Bloomberg) -- Tempting as it is to credit the stock market’s rollicking advance to expectations the economy will thrive despite war and inflation, other forces are at work in the rally.
How much they are responsible for is a serious question for traders and central-bank modelers alike.
Down only three times in two weeks, the S&P 500 has now soared 11% since mid-March to post one of its strongest gains over comparable periods in the last decade. The rebound, defying recession alarms from the bond market, has recouped almost three quarters of its losses from January and February.
Before assigning an economic narrative to the bounce, it’s useful to consider some of the constituencies who have helped fuel it. They include pension funds snapping up shares as the quarter rolls over, computer-driven traders programmed to add equities when volatility plunges, and short sellers forced to buy back borrowed stocks when prices rise.
Their actions help explain why stocks have kept rising despite outflows from equity funds, and add fuel to warnings from some Wall Street analyst that the gains are a bear-market rally. The buying from these groups reflected a need to adjust to market movements, rather than genuine demand driven by improving fundamentals.
“I question how sustainable it is -- there is a lot of technicals,” said Michael Purves, founder of Tallbacken Capital Advisors. “You need to see fundamental investors come in and feel comfortable buying this dip. But to do that, they’re going to need to see some stability in the back of the Treasury curve and earnings are going to need to be good.”
With earnings season still two weeks away, investors are left with few clues on how corporate America is navigating runaway inflation and the Federal Reserve’s first rate hike since 2018. Meanwhile, parts of Treasury curve have inverted, spurring concern that the central bank’s campaign to tame price gains could send the economy into a recession.
All the uncertainty generated by the Fed and the war in Ukraine sent the S&P 500 as much as 13% from its all-time high in mid-March. At that time, JPMorgan Chase & Co. (NYSE:JPM) projected pension and sovereign wealth funds would need to rebuild equity holdings that had fallen in value, with a potential buying spree totaling $230 billion.
Whether the subsequent rally was aided by actual pension rebalancing or other investors buying stocks in anticipation of that is hard to determine. Regardless, the move has been powerful. The S&P 500 has jumped 11% and reclaimed major trendlines such as its 200-day moving average. The Cboe Volatility Index plunged to the lowest level in more than two months.
In some ways, the rally has started a cycle that drives macro systemic strategies to load up on stocks. These funds, using momentum and volatility signals to guide trades, had spent the previous few months betting against the market.
In the week through Monday, quant funds, including volatility-targeting funds and trend-following commodity trading advisers, purchased $25 billion of equity futures, according to an estimate by Charlie McElligott, a cross-asset strategist at Nomura Holdings (NYSE:NMR).
A similar dynamic played out on the individual-stock level. Richly valued shares, targeted by short sellers during the rout earlier this year, are outpacing the market on the way up as bears have capitulated.
A Goldman Sachs Group Inc (NYSE:GS). basket of the most-shorted companies has surged 27% since its March trough, more than double the S&P 500’s gain over the stretch.
“Leveraged investors have participated in the current sell-off by aggressively reducing their equity exposure,” Goldman strategists led by David Kostin wrote in a note. “Short covering by these participants helps to explain why some of the longest duration equities have recently risen sharply in the face of rising interest rates and a more hawkish Fed.”
While the rally may have emboldened some buyers, it has yet to revive animal spirits broadly. Even as stocks climb back toward all-time highs, sentiment is stuck at levels worse more depressed than during the dark days of the pandemic, according to Goldman’s equity sentiment indicator that tracks everything from retail activity to money flows and fund positioning.
From a contrarian’s perspective, the lack of faith means potential buying power, and the only missing ingredient is some kind of catalyst to convince skeptics that the bull market will live on.
What that catalyst could be is up for debate, though one argument gaining traction is that stocks can work as a hedge against inflation. Indeed, analyst estimates have stood firm during this year’s turmoil, a clear sign of corporate resilience.
How much investors are willing to pay for those profits is the main variable that will influence the market, according to Dennis DeBusschere, the founder of 22V Research. He points to a wild swing in price-earnings multiples as the culprit for this year’s market chaos. With borrowing costs poised to rise in coming years, he sees a ceiling in equity valuations.
At 20 times earnings, the S&P 500 was traded at an elevated ratio that before the 2020 pandemic had happened only once in the past two decades -- the dot-com era.
“Be skeptical of chasing the latest narrative,” said DeBusschere. “Financial conditions are likely to tighten and are a headwind for P/E, which limits upside.”
©2022 Bloomberg L.P.