Investors are buying into the idea of a cyclical recovery, the idea that the Federal Reserve “pulled off” a soft landing.
The market’s anticipation of such a recovery is largely based on the assumption that the Fed will loosen monetary policy at the exact right time before some major credit event takes place. This would entail lowering interest rates, which stimulate economic growth by making borrowing cheaper.
This is a double-edged sword. On one hand, it can stimulate economic expansion. On the other hand, it can also lead to inflation and financial instability.
Most importantly, stocks tend to suffer meaningful declines AFTER the Fed begins its pivot. Cutting rates suggests that the Fed overtightened and something likely already broke.
That’s why tail risk remains. The term “tail risk” refers to the risk of an investment moving more than three standard deviations from its current price. It represents an event with a small probability but severe potential impact. The market seems to be underpricing such a risk now. This could be due to a variety of factors, including a lack of awareness, optimism bias, or simply a lack of tools to accurately price such risks.
The current market rally may seem promising, but it’s crucial to question its sustainability.
The rally is being fueled by the anticipation of a major policy shift by the Federal Reserve and an uptick in stocks linked to cyclicality and seasonality. However, both factors are uncertain. China’s economic chaos and the continued underperformance of small-cap stocks are both signs that such an uptick may not come.
I remain skeptical. This is, was, and will be about path. The market’s optimism for a cyclical recovery and a loosening of monetary policy by the Fed is a double-edged sword. While it presents opportunities, it also presents risks.
So, what does this mean for you? Enjoy the rally while it lasts, but don’t expect it to last for long.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
