Wall Street is certainly enjoying itself again to start the new week. The S&P 500 surged by 2.3% yesterday, its best performance since April, as falling oil prices and hopes of a de-escalation in the US-Iran war gave investors a reason to pile back into stocks.
Fair enough. Cheaper oil prices help to take some pressure off inflation, which then eases the squeeze on corporate costs and household spending. So, that’s good news for stocks especially after the brutal selloff last week.
But now, what happens when all that optimism is starting to get priced into markets? Let’s think about if for a second. A potential end to the Middle East conflict removes one major source of uncertainty for equities. However, it doesn’t necessarily give stocks a fresh catalyst to keep pushing higher endlessly.
As such, I would argue that there are three things worth watching to judge whether this latest rebound has any staying power.
The first one is that Treasury yields need to also play along.
10-year Treasury yields are hovering just below 4.90% and that’s hardly an invitation for investors to throw caution to the wind. If oil prices keep falling but bond yields remain elevated, any real benefit to equity valuations could prove to be limited once the dust settles.
Adding to that, Washington’s fiscal outlook isn’t helping either. Persistent deficits and heavy borrowing requirements could continue to underping long-term yields especially, even as geopolitical risks fade.
Besides that, cheaper oil alone isn’t going to change the Fed’s thinking overnight. Markets are still pricing in roughly an 84% chance of a December rate hike, so there are still some hawkish undertones for traders to manage. The first test of which will come later today from the US CPI report.
The second thing is to see whether the equities rally can broaden beyond the usual suspects.
The rebound yesterday was definitely encouraging, with all 11 sectors of the finishing higher and the Russell 2000 gaining by 3.1%. The question now though is can that very momentum continue?
If small caps, industrials and consumer discretionary stocks keep participating, that would suggest investors are buying into a healthier economic outlook rather than simply chasing another technology rebound. As for a rally that is carried by fewer and fewer stocks? Well, that’s a completely different story.
And lastly, earnings also need to pull their weight and justify the enthusiasm.
Now, the AI spending debate hasn’t disappeared just because oil prices are falling. Investors still need a lot of convincing that the enormous capex commitments will eventually translate into sustainable profit growth. But if valuations keep rising faster than earnings expectations, we’re only likely to see the market turn to become more vulnerable to another disappointment.
So, that is the broader picture that I’ll be watching next even as geopolitical tensions start to ease from hereon.
A genuine de-escalation in the US-Iran war could certainly lay the groundwork for a sustained recovery. However, I’d also want to see falling bond yields, broader equity participation and stronger earnings expectations to reinforce that optimism.
Otherwise, we could end up with a case of market players already buying into the good news but haven’t quite figured out what comes next. And that’s when the easy part of the rally comes to an end.
This article was written by Justin Low at investinglive.com.
