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Stock Market Outlook: Caution Ahead

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JPMorgan Chase & Co. Chief Market Strategist, Marko Kolanovic, warns investors that the recent surge in the U.S. stock market may not be sustained. In a note to clients, Kolanovic highlights several challenges that could potentially lead to a decline in stocks in the fourth quarter.

Fed’s Stance and Economic Slowdown

Kolanovic notes that falling bond yields and recent dovish central bank meetings may currently be viewed as positive by equity markets. However, he believes that this sentiment will soon shift as the Federal Reserve indicates its reluctance to further cut interest rates amidst a slowing economy. He explains that several factors contribute to this cautionary outlook.

Headwinds for Equities

The strategist points out that equities are likely to become less attractive in terms of risk-reward. First, with the Fed maintaining higher rates for an extended period, the prospects for stocks dwindle. Moreover, Kolanovic highlights the rich valuations, overly optimistic earnings expectations, diminishing pricing power, and vulnerable profit margins. Additionally, the slowdown in topline growth adds to the concerns.

Fed’s Impact on Markets

Last week, the stock market experienced a significant increase following indications from the Federal Reserve that it could stop raising interest rates. The rise in Treasury yields has played a role in tightening financial conditions. However, Kolanovic argues that relying solely on the Federal Reserve’s actions and its impact on market dynamics poses risks.

The “Bad News is Good News” Scenario

Investors have reacted positively to survey data and indicators, such as the Federal Reserve’s Beige Book, pointing towards an economic slowdown and potential decrease in inflation. This counterintuitive response is driven by the expectation that a moderate economic slowdown might prompt the Fed to resume interest rate cuts. Consequently, this would enhance the attractiveness of equities compared to bonds and cash.

Despite this perspective, Kolanovic cautions that this “bad news is good news” dynamic carries its own set of risks. Beyond a certain threshold, the potential drawbacks posed by a sluggish economy would begin to outweigh the benefits for the stock market.

In conclusion, Kolanovic’s assessment highlights the need for caution in the current stock market environment. It is clear that there are various challenges and uncertainties that could dampen the optimism seen in recent weeks. Investors should remain vigilant and manage their expectations accordingly.

The Narrow Line between Good News and Bad News

In today’s volatile market, it can be challenging to discern between a healthy economic slowdown and the early stages of a recession. This lack of clarity highlights the narrow zone where “bad news is good news,” as explained by Kolanovic, a renowned analyst at JPMorgan.

A Fed policy “mistake” could potentially amplify risks for stocks. This refers to the Federal Reserve keeping interest rates higher for an extended period, which may have detrimental effects on the economy. As a result, we could witness a recession and a significant decline in corporate earnings growth, creating serious problems for stocks.

With the Fed likely to maintain higher rates in the short term, markets may start to factor in the possibility of a policy misstep. This anticipation of a mistake could lead to lower long yields down the line, which might not bode well for stocks. Particularly concerning would be if 2024 earnings projections begin to readjust lower, adding further pressure on stock performance.

Kolanovic is not the only notable figure on Wall Street who is skeptical about the recent rally in stocks. Michael Wilson, who has had differing views from Kolanovic in the past, recently expressed his belief that this rally could soon lose momentum. Wilson expects investors to reevaluate their expectations for rapid corporate earnings growth in 2024.

Last week, U.S. stocks experienced a substantial surge, marked by impressive gains in major indices like the Nasdaq Composite, S&P 500, and Dow Jones Industrial Average. This rally coincided with a decline in Treasury yields and the weakening of the U.S. dollar.

Market optimists were particularly encouraged by the broad-based nature of the rally. Even unprofitable technology stocks represented by the Ark Innovation ETF and regional banks that were previously struggling posted double-digit gains. Additionally, small-cap stocks represented by the Russell 2000 outperformed the highflying Nasdaq Composite, offering hope that neglected segments of the market may be experiencing a revival.

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