Cautious optimism led stocks back to all-time highs. But are bulls becoming irrationally exuberant?
“Triumph of the Optimists” is a landmark history of investment returns during the 20th century. The story of past several weeks in markets could be called, “Redemption of the Cautious Optimists.” From the start of August, after a startling weak jobs report, the markets locked into investors’ preferred scenario: The Federal Reserve would soon lower interest rates — but not because the real economy is in need of urgent help. This allowed a somewhat extended equity rally as of the end of July to flatten out, cooling off overheated momentum stocks, offering relief to the lagging sectors, suppressing volatility, draining away some excess investor optimism and extending the S & P 500’s run without as much as a 3% pullback beyond four months. This week’s mix of elevated but as-expected CPI inflation and a possibly fluky uptick in weekly unemployment claims cemented the outlook for an easier Fed while preserving the prevailing view that the underlying economy is steady or better. In this crowd-pleasing version of reality, the soggy-seeming labor market is providing markets and policy makers with “just the right amount of wrong,” as the old advertising catchphrase for a Las Vegas casino hotel put it. Once one believes that the stalled jobs market is either an anomaly (due to immigration crackdowns, demographics and a sharp but fading tariff-driven confidence shock among companies), it’s a quick hop to deciding that the Fed next week will embark on “good news rate cuts.” It also allows an investor to argue that Treasurys have rallied hard — dropping yields to five-month lows — for good reasons. And that gold is roaring to new records not because the Fed is losing credibility or systemic macro risk is rising, but because institutions are prudently diversifying away from the dollar as the fiscal taps open wide across the world. Credit markets, for their part, offer testimony in favor of this theory, betraying minimal concern about economic stress or corporate solvency, with high-yield debt spreads near their most compressed readings of this cycle, Bespoke Investment Group notes, on “the assumption Fed rate cuts will support activity without much fear over damaging inflation, and investment grade-rated assets are showing the same optimism.” Economists and many investors have been sensitive to a possible “stagflationary” mix of factors, which if they worsened could vex markets and confuse policy makers. In short, at this moment, this refers to sticky, above-target inflation coexisting with slowing underlying growth and weakening employment. This is the dynamic no one wishes to see gain traction from here, though current levels of inflation between 2.5% and 3% are pretty unremarkable looking back a few decades, easily handled by equity markets so long as they don’t provoke a tighter Fed. And in absolute terms, the starting point is relatively benign, as gauged by the “misery index,” simply the sum of the unemployment rate and CPI. Are we there yet? The market action itself is not serving up many persuasive causes for acute concern. The S & P 500’s breakout to new highs on Thursday after the CPI and weekly jobless claims releases was broad, led by the kind of cyclical-bellwether groups one might hope to see out ahead (homebuilders, semiconductors, small-caps, equal-weight indexes, banks). The bulls have also anchored to the limited but reassuring history of periods when the Fed cut rates after a long pause while the stock market was near a high. The market did well afterward, thanks largely to the vaunted mid-1990s glory days when the Fed engineered the pristine soft economic landing alongside a generational boom in technology investment. As a sidebar, Strategas Research points out it’s been rather rare for the Fed to be cutting rates when the bank-stock indexes were near a record high, as they are now. Here again, some fruitful investing phases in the early and mid-1990s precedent shine bright. Such history is helpful to know and worth keeping in mind, though the past cycle has confounded plenty of time-tested patterns. The current bull market is the first to have begun while the Fed was still tightening. A couple of years of an inverted Treasury yield curve never led to a recession as it was supposed to. The tape is now a bit stretched, and sometimes a big rally on a day when data confirms the primary bullish thesis can be a short-term culmination of an advance rather than the start of something new. The bond market, conspicuously, priced in the dovish pileup of data first, the 10-year sliding to just above 4% by Tuesday, and yields retraced a bit higher by week’s end. While the idea that a rate cut next week could be a “sell-the-news” event became a suddenly popular call late this week, it’s plausible given that the value of a rate cut for stocks right here is arguably as something to anticipate as an excuse to add risk, rather than celebrate for its tangible benefits after the fact. Bespoke notes the S & P 500 , after this week’s 1.6% climb, registered as “extreme overbought,” two standard deviations above its 50-day moving average, for the first time since December. The market, perhaps counterintuitively, tends to do better than average following such readings when they come in a broader uptrend, proof that market trends are persistent. Still, that December instance led to two months of minimal upside progress before the first-quarter momentum unwind and tariff sell-off took hold. The monstrous rally in Oracle shares this week after its transformative multiyear revenue guidance tied to AI data-center services recharged an AI theme that was having one of its periodic gut checks. Nvidia shares looked fatigued and many questions surfaced about the whether the infrastructure buildout would grow redundant and increasingly dependent on debt financing. It’s one of those times when the rally has proven sturdy enough to deserve the benefit of the doubt while an open-minded market participant will acknowledge that prices, valuations and attitudes have ascended to heights that leave less room for error and more for potential disappointment. The 6,600 level on the S & P 500, which was touched intraday on Friday almost on the nose before the index sagged to finish at 6584, has been a longstanding upside target by for some perspicacious technical market handicappers since late last year, including strategists Craig Johnson of Piper Sandler and John Kolovos of Macro Risk Advisors. Kolovos leaves open the prospect that the index can get to 7,000 by early next year, though near-term he flags a recent drop in the price correlation among the “Magnificent Seven” stocks to historic lows as “a sentiment indicator suggesting complacency.” This is a localized metric, not proof of broad-scale reckless. Low correlation speaks to a lack of concern about market-wide risks. Speaking of the Magnificent Seven, this group still trades at a healthy valuation premium to the rest of the market, though this margin has narrowed, largely as the broader field has grown more expensive. Granting that valuation itself has little predictive potency over a one-year horizon, there’s no denying that equities are pretty rich here, with the “other 493” S & P 500 components now at 20-times year-ahead earnings. The persistence of earnings growth, quality of business models, strength of balance sheets and reduced tax and regulatory burden on companies might be fair explanations for such valuations — but none of that makes them bargains. The market finds itself at an interesting juncture, with investors suddenly feeling pretty certain about the macro picture and the implications of the Fed’s path from here, and with the bull-market muscle-flexing just beginning in the form of meme-stock revivals, hype-propelled IPOs and splashy M & A deals. Elaine Garzarelli of Garzarelli Capital — yes, the famous strategist known for having called the 1987 crash and subsequent market turns in the 1990s — suggests in her weekly market piece that the S & P 500 can hold its high valuation and continue to make progress along with earnings growth, in part because animal spirits are just now revving up: “Like before, stocks should respond favorably to a possible rising persistent trend of improving confidence into irrational exuberance territory as IPOs, small caps, and other laggards begin to excel. So, even though the S & P 500 is a bit overvalued, irrational exuberance is not yet here.” Of course, we may not be promised an exuberance phase this time around, but one surely cannot be ruled out, after investors this year have progressed through a “Sell America” panic, a “better-than-feared” rebound and a couple of months of cautious optimism, leading them to exactly the setup the bulls have told themselves they wanted. 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