Investors in a Bind as Risk Appetite Slams Into a Resolute Fed

(Bloomberg) — Stock-market investors clamoring for a sense of direction after a month of yo-yo action are bracing for a week chock-full of economic data and Federal Reserve speakers that should help clarify the next step for US equities.

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This year started with a torrid rally, but that’s given way to the S&P 500’s first two-week losing streak since December. The risk now is that mounting bets on steeper interest-rate hikes are wearing down the market’s resilience. Investors who are fearful of a return to the dark days of 2022 could be nearing a breaking point where they start to yank cash at a brisker pace.

The warning signs are everywhere. Fed officials are talking up another jumbo rate increase. Inflation is more stubborn than anticipated. And Wall Street’s most vocal bears see nothing but pain on the horizon. All of which has traders weighing the threat of their 2023 gains vanishing against the potential for another swift recovery.

“If we do have a more substantial downturn, investors could be quick to pull the trigger,” Frank Cappelleri, founder of research firm CappThesis, said by phone. “Stop-losses could really be in play because the worst-case scenario is on everyone’s mind already — and that’s testing new lows again.”

The flurry of economic updates ahead may cement investors’ view of the Fed’s policy path. The holiday-shortened trading week brings readings on manufacturing, the health of the consumer and US economic output. That’s on top of minutes from the Fed’s most recent meeting and speeches from a range of officials, including Cleveland Fed President Loretta Mester, who said last week that she saw a “compelling economic case” for a half-point hike at the central bank’s last gathering.

It’s a stretch that may help confirm whether this year’s equity rally is the beginning of a bull market or yet another bear trap. On one side, JPMorgan Chase & Co.’s Marko Kolanovic, for one, sees a “prevailing sentiment of exuberance and greed.” On the other, Wells Fargo & Co.’s Chris Harvey declared the bear market over.

The S&P 500 is essentially flat this month, after a 6.2% January surge. That rally was likely fueled in part by short-sellers covering bearish bets and buying from systematic investors that drew in momentum players, analysts say.

A red flag is emerging from Corporate America during this earnings season. Profit growth has turned negative on a year-over-year basis, which has happened just four other times in the past two decades and has never been an encouraging sign for stocks.

There’s another big question mark looming in an uptick in trading of short-dated options. That activity has amplified daily swings, adding to the noise and creating a further potential source of risk. This week, volume for contracts that expire on the same day they’re traded hit a record 50% share of all the options transactions on the S&P 500, data from CBOE and Nomura show. It’s a backdrop that’s creating a risk on the scale of the market’s early-2018 volatility implosion, according to JPMorgan’s Kolanovic.

And yet some investors are finding solace in looking ahead to forecasts for profits to rebound in 2024, and optimism that a soft landing and mild recession are not just achievable, but expected.

“The upshot is that fear of missing out (FOMO) has made a comeback,” said Ed Clissold, chief US strategist at Ned Davis Research Inc. “Even some investors who doubt the Fed can engineer a soft landing have begrudgingly gotten on board.”

While sentiment and fund flows show a mixed bag of skepticism and optimism, there could be room for further gains, he added. “Sentiment appears to be far from the excessively optimistic levels that are often seen at major market peaks.”

One group that’s been buying relentlessly is retail traders. Individual investors purchased a net $32 billion in US shares and exchange-traded funds over the 21 sessions through Thursday, a record for such a span, Vanda Research data show. While that pace may be hard to sustain, there’s enough cash for the group to make risky bets if institutional investors step in to fuel a stronger rebound, writes Vanda’s Marco Iachini.

Amid the overarching debate over the economy and Fed policy, chart watchers have their own take. They point to the market’s stability into the end of 2022 as a sign the rebound has support and are monitoring those levels as stocks sputter. The S&P 500 hit an intraday low of 3,764 on Dec. 22, nearly 8% above the bottom in October, creating a pattern of a higher low.

“The market can break out from here, but if that fails then that’ll show that the biggest patterns,” which are bullish now, could be negated, says Cappelleri.