Wall Street has been navigating a turbulent landscape recently, with the CBOE VIX index—a key measure of expected volatility in the S&P 500—reaching 18 midweek. This marks its highest level since April and reflects heightened investor unease. The surge in volatility has been attributed to intense selling of large-cap technology stocks, which has rattled the markets. Amid this backdrop of uncertainty, there has been significant discussion about a potential rotation into smaller companies that might benefit from lower interest rates and a still-robust economy. This shift is seen as a reaction to waning enthusiasm for AI-linked stocks.
However, John Higgins, Chief Market Economist at Capital Economics, casts doubt on the sustainability of this narrative. Higgins suggests that a substantial and sustained rotation into small-cap stocks is unlikely until just before a major market bubble bursts, with his baseline assumption being that such a bubble may not burst until 2026. Drawing a parallel with the dotcom bubble of the early 2000s, Higgins argues that AI, while transformative, may follow a similar trajectory, with investors continuing to seek early gains from emerging technologies.
Higgins anticipates that the S&P 500 could rise to 7,000 by the end of 2025 as the market bubble reflates. He predicts that this would result in a price-to-earnings (P/E) ratio of 25 for the index, comparable to the peak seen during the dotcom era. Currently, the S&P 500’s forward P/E ratio stands around 21, suggesting that valuation expansion rather than earnings growth might drive future gains.
This environment presents challenges for value-oriented fund managers like Chicago-based Distillate Capital. In its second-quarter 2024 update letter, Distillate acknowledges that its valuation-focused strategy has led to some of its funds underperforming relative to the broader market. The fund manager, which emphasizes the use of free cash flow yield as a valuation metric, argues that traditional metrics have become less relevant in an increasingly asset-light world. Despite this, Distillate notes that valuation alone is insufficient for predicting short-term stock-market returns. Instead, the firm emphasizes that the price paid for stocks has a significant impact on long-term returns.
Distillate highlights that the S&P 500’s current trailing free cash flow yield of 3.3% ranks in the 14th percentile of its 40-year history, indicating that the market has been less expensive only 14% of the time. This suggests that current market valuations are relatively high compared to historical norms, which could impact long-term returns.
In recent market developments, U.S. stock indices have opened higher as benchmark Treasury yields edge lower. The dollar index remains steady, while oil prices have dipped, and gold is trading around $2,379 an ounce. Key asset performance metrics show the S&P 500 with a year-to-date gain of 13.20%, and the Nasdaq Composite up 14.46% over the same period. Notably, the 10-year Treasury yield has increased by 36.31% year-to-date, reflecting rising interest rates.
In addition to these market movements, the Federal Reserve’s monetary policy decisions are under intense scrutiny. Wall Street is largely anticipating that September will bring a cut in the base interest rate from Fed Chairman Jerome Powell. This expectation is driven by growing concerns that the economy may be heading toward a recession. However, some experts caution that it may already be too late to prevent an economic downturn.
Goldman Sachs and UBS are among those predicting that the Fed will initiate its first rate cut before the November presidential elections. Yet, they do not expect this to happen at the Fed’s July meeting. This delay could provoke criticism from political figures like Donald Trump, who has been vocal about his dissatisfaction with current monetary policies.
Bill Dudley, the former president of the Federal Reserve Bank of New York, has recently revised his stance on interest rates. Previously a proponent of maintaining higher rates, Dudley now argues that the Fed should cut rates as soon as possible. In a Bloomberg opinion piece, Dudley attributes his change of mind to new economic data that suggests a need for more aggressive monetary easing.
Dudley points to recent observations by Bank of America CEO Brian Moynihan and Citigroup CEO Jane Fraser, who have noted emerging vulnerabilities among consumers, particularly at the lower end of the income spectrum. Data from the St. Louis Fed shows troubling trends, including a 23% increase in car repossessions compared to the previous year and a rising delinquency rate on consumer loans. These indicators, coupled with a slight uptick in unemployment, have led Dudley to advocate for immediate rate cuts, even if it might be too late to avert a recession.
Central to Dudley’s argument is the Sahm Rule, a recession indicator developed by macroeconomist Claudia Sahm. The rule examines the current three-month moving average of U.S. unemployment and compares it to the lowest three-month moving average from the past year. If the current average exceeds the lowest average by more than half a percentage point, it signals a potential recession. For June 2024, the Sahm Rule’s figure was 0.43 percentage points above the benchmark, suggesting an increased risk of recession.
Despite these signs, Fed officials have been cautious about implementing rate cuts. Federal Reserve Governor Christopher Waller has indicated that while the time for rate cuts is approaching, it has not yet arrived. Similarly, New York Fed President John Williams has noted positive signs regarding inflation but emphasized the need for more data before making any decisions on rate cuts.
Dudley outlines three reasons why the Fed might be hesitating. First, the Fed may be wary of repeating the mistake of prematurely declaring victory over inflation, as was the case with last year’s temporary moderation. Second, Powell might be aiming to build broad consensus among Fed members, ensuring that officials like Waller and Williams are fully informed before making a decision. Finally, Dudley suggests that the Fed may be underestimating the Sahm Rule’s predictive power, arguing that rapid labor force growth, rather than increased layoffs, could be influencing the unemployment indicator.
In summary, while the market anticipates a potential rate cut in September, the Federal Reserve faces a complex decision-making process. The mixed signals from economic indicators and the cautious stance of Fed officials highlight the challenging environment for policymakers as they weigh the risks and benefits of adjusting interest rates.