Investors Can Fight the Fed All They Want. Don’t Fight the Tape

(Bloomberg) — Ignoring the Federal Reserve’s determination to keep raising rates and hold them there is a wildly profitable trade on Wall Street right now. It’s trying to swim against the rising market that carries risks.

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“Fighting the Fed” has actually been a winning stock-market strategy for months. The S&P 500 Index is up 15% since the start of the fourth quarter and 16% from its October low, putting it within striking distance of the 20% threshold many investors define as the start of a bull market.

Meanwhile, the central bank has raised rates three times, says more hikes are coming and continually insists that it’s going to keep the fed funds rate high for a while. But to the stock market the reaction has been, who cares?

The bet seems to be that those hikes have been priced into stocks and that the Fed will actually be able to pull off a soft landing, where it tames inflation while the economy continues to grow. And that’s put rate-wary and inflation-worried traders in the challenging position of slamming head-first into the prevailing market momentum.

“What if the Fed actually wins? It appears it is,” said Adam Sarhan, founder of 50 Park Investments, who is long US equities, including battered technology shares like chip stocks. “Investors are rewarded when they align themselves with the underlying trend on Wall Street. Never fight the tape and keep your losses small.”

Of course, the risk the herd of bullish investors faces was clear in Friday’s gangbuster jobs report — the possibility of stubbornly high inflation. If a healthy labor market keeps wage growth up, prices may not come down. And that would prevent the Fed from pausing its most aggressive tightening cycle in decades.

Bullish Sectors

One reassuring factor to equity optimists is the shift in market leadership. The sectors leading this year’s rebound, like consumer discretionary and information technology, have historically outperformed during the early stages of bull markets, according to investment research firm CFRA. The same goes for materials stocks, which have been outperforming since late September.

History also says that whether there’s a recession or not will be crucial for stocks. Since World War II, there have been nine bear markets that have been accompanied by recessions, and on average the S&P 500 has declined 35% versus 28% for bear markets that didn’t come with economic downturns, CFRA data show.

What’s particularly interesting is there have been just three bear markets since 1948 without recessions. And each time a new bull market started within five months of stock prices hitting a low.

Sam Stovall, chief investment strategist at CFRA, is sticking with his optimistic call for US equities even though he thinks a shallow recession may still occur. His rolling 12-month target of 4,575 for the S&P 500 is 11% above Friday’s close.

“Could we be in store for a more severe bear market, or will there be a very mild downturn this year and the stock market already bottomed?” Stovall said. “I believe we’re in a new bull phase.”

Stovall has a point. To stocks, even if there’s a recession, it’s the length that really matters. The depth of peak-to-trough real GDP declines isn’t historically correlated to the severity of moves in equity markets, according to Gina Martin Adams, chief equity strategist at Bloomberg Intelligence. But shorter recessions have led to more rapid rebounds.

Forecasters surveyed by Bloomberg are predicting that the economy will contract in the second and third quarters of this year before recovering at year-end.

Technicals Rule

Even steadfast bears are growing more optimistic — for now.

Doug Ramsey, chief investment officer at Minneapolis-based Leuthold Group, said the firm added to its equity exposure at the start of the year. And although he thinks the US may have a recession later this year, he plans to ride the latest rally for the time being based on improving technicals.

“Historically, there’s been an opportunity to make money in stocks between the initial inversion of a yield curve and a peak in stocks prior to a recession,” Ramsey said. “It feels dicey for many. Some may think that’s like trying to grab a few nickels in front of a steamroller, but I’m not sure that’s right. We could be picking up gold coins in front of a tricycle — and this could be worthwhile.”

Longer-term, Ramsey is wary of a head fake. The sectors that outperform in a soft-landing scenario are often similar to those that do well leading up to a recession. For example, materials producers and industrial companies — two value sectors that have held up well in this year’s growth rally — usually perform strongly in the six months ahead of a downturn.

Naturally, long-term optimists are looking past that. To them, a recession is increasingly unlikely and inflation is coming down, which is what the Fed wanted to do. So the arrow is pointing up, and there’s little sense in fighting the tape.

“Inflation is coming down and we don’t have a threat of a severe recession,” Sarhan of 50 Park Investments said. “As far as I’m concerned, the bear market for all intents and purposes is over.”