Why Is the Stock Market So Strong?

Since last March the Federal Reserve has been elevating its target rate — with fantastic abandon.

Across that same frame it has been chewing into its balance sheet.

Meantime, the bond market is putting out the loudest recession warnings since 1982.

Wobbles to the banking system have likewise clouded the economic outlook.

It is a formula toxic to the stock market.

That is, in theory it is a formula toxic to the stock market.

Yet the stock market has ventured upon a lovely spree since October last.

It has climbed its wall of worry.

The S&P 500 has not absorbed even a 3% trimming since March.

This tranquil stretch is among the longest since 1928.

To what do we owe this splendid stock market levitation?

The AI Theory

Is the stock market spreeing because investors have have gone delirious over the artificial intelligence mania — and are shoveling up stocks that touch it?

There is evidence in back of the theory.

The “Big 7” — Amazon, Apple, Microsoft, Google, Tesla, Facebook and Nvidia — account for nearly all market gains this year.

In particular, three of these draft horses have hauled the bulk of the freight. They have taken the broader market in tow… and dragged it along.

Without them the S&P 500 would have scarcely budged a jot this year.

Observes money man Mr. Doug Kass:

Taken in a broader context, over 100% of all the gains this year in the S&P index have been driven by seven stocks. Three of those seven stocks account for 68% of the S&P’s entire yearly gains.

Affirms Mr. Lance Roberts of Real Investment Advice:

Since the end of January, despite the Fed hiking rates, a bank solvency crisis and weakening economic data, the market has continued to “climb a wall of worry.” In fact, not only did it climb a wall of worry, investors latched onto a whole new investment theme of “artificial intelligence.”

The current chase for stocks related to “artificial intelligence” has undoubtedly grabbed everyone’s attention. Retail investors are jumping back into the markets with both feet for the first time since last year. The shift from bearish to bullish sentiment has been steady…

There is therefore justice in the artificial intelligence theory of market superperformance.

We hazard investors will one day pile out of these stocks as rapidly as they piled in. But that is for another day.

Here is the central question: Does the Artificial Intelligence fixation fully and completely explain the market joy?

Perhaps not.

Living off Monetary and Fiscal Fat

Perhaps it is because the stock market — and the economy itself — feed yet off the monetary and fiscal fat whipped into existence these past few years?

Mr. Roberts:

[Because of] the massive fiscal and monetary supports of 2020 and 2021, despite higher rates, the economy and, by extension, the stock market, may be more resilient than expected…

M2, a measure of monetary liquidity, is still highly elevated as a percentage of GDP.

This monetary liquidity yet lubricates the economic and financial apparatus.

It has not been wrung from the system — despite the consecrated and frantic efforts of the Federal Reserve.

The Federal Reserve has been chasing after the inflation it helped turn loose upon the United States.

Yet until recently it has lagged far behind inflation… and so its tightenings were merely attempted tightenings, failed tightenings.

In real terms — in real terms — the Federal Reserve was more accommodating than restricting.

Explains Mr. Keith Wade, chief economist with asset management firm Schroders:

The first rate rise came on March 16 last year when the U.S. central bank raised the target range for the fed funds rate from 0–0.25%, up to 0.25–0.5%. Rates had been held at close to zero for nearly two years having been slashed in response to the pandemic. Thereafter rates did rise sharply to their current range of 5–5.25%; however, they remained below inflation throughout and arguably only became restrictive in real terms toward the end of last year. [Emphasis ours.]

Although this has often been described as an aggressive hiking cycle as measured by the speed with which rates have risen, given the low starting point it has taken some time to get rates to a level where they can be considered restrictive. Consequently, the time taken from the first rate rise to when it has been able to impact the economy has been extended.

There you have the monetary facet. What about the fiscal facet?

The Inflation “Reduction” Act

Recall, the government of the United States went amok during the pandemic year of 2020.

The geysers of money it blasted into economic circulation staggered the sober senses and outraged the conscience.

The government of the United States remains amok in 2023. And it still has the geysers going.

Here the abovesaid Roberts cites the Inflation Reduction Act, so-called. The abomination is another source of market liquidity:

One aspect of monetary support that much of the mainstream media overlooks was the massive Inflation Reduction Act of $1.7 trillion that was on top of the more than $5 trillion in direct stimulus payments during the pandemic era…

In 2022 the Biden administration was finally able to force through $1.7 trillion in federal spending in the Inflation Reduction Act. Those funds are getting spent in 2023 to start various projects, which will provide economic support in the near term, regardless of their success or failure.

In the first quarter of 2023, federal spending increased by 3% on a quarter-over-quarter basis. Using that increase as a baseline, we can project federal spending through the end of the year, which will eclipse $7 trillion at the current run rate…

The point here is that while many economists and analysts are predicting a sharp slowdown and recession later this year, which is indeed possible, there is still a lot of liquidity supporting economic activity (and market strength) in the near term.

Thus this liquidity — ultimately counterfeit liquidity — may heavily explain the stock market’s energetic romps this year.

We hazard the artificial intelligence theory lags behind the liquidity theory.

Mr. Larry Berman is the co-founder of both ETF Capital Management and Quintessence Wealth. From whom:

Do not believe for a minute that Microsoft and Apple should be trading at 30X-plus multiples were it not for the abundant liquidity the central banks have created despite what Wall Street analysts would have you believe with their AI growth stories. They are both great companies, they are just hugely overvalued today.

We are with him.

The Fuse Is Lit

Yet we would remind the stock market enthusiasts that policy — monetary policy at least — runs to a lagging schedule.

The fuse may burn 18 months or more before the detonation. It is that long.

The Federal Reserve sparked the fuse last March… 16 months distant.

Thus the fuse is burning.

Not only is it burning — it is very far along. How much fuse remains is a matter of speculation.

We concede the possibility that the bomb itself will fail to detonate. It may indeed prove a dud… and the stock market may continue its spree.

Past bombs with burning fuses have failed to detonate, it is true.

Yet are you willing to place that wager?

Are you willing to hold the bomb in your hands?