Why the stock market’s ‘FOMO’ rally stalled out and what will decide its fate

Financial market participants this past week moved closer to pricing in what the Federal Reserve has been telling them: the fed-funds rate will peak above 5% and won’t be cut in 2023. Fed-funds futures as of Friday were pricing in a peak rate of 5.17%, and a year-end rate of 4.89%, noted Scott Anderson, chief economist at Bank of the West, in a note.

After Fed Chair Powell’s Feb. 1 news conference, the market still expected the fed-funds rate to peak just shy of 4.9% and end the year at 4.4%. A red-hot January jobs report released on Feb. 3 helped turn the tide, alongside a jump in the Institute for Supply Management’s services index.

Meanwhile, the yield on the policy-sensitive 2-year Treasury note
TMUBMUSD02Y,
4.510%
has jumped 39 basis points since the Fed meeting.

“These dramatic interest rate moves on the short end of the yield curve are a large step in the right direction, the market has begun to listen, but rates still have a ways to go to reflect current conditions,” Anderson wrote. “A Fed rate cut in 2023 is still a long shot and robust economic data for January give it even less of a chance.”

The jump in short term yields was a message that appeared to rattle stock market investors, leaving the S&P 500
SPX,
+0.22%
with its worst weekly performance of 2023, while the previously surging Nasdaq Composite
COMP,
-0.61%
snapped a streak of five straight weekly gains.

That said, stocks are still up smartly in 2023. Bulls are becoming more numerous, but not so ubiquitous, technicians say, that they pose a contrarian threat.

In a mirror image of 2022’s market meltdown, previously beaten down tech-related stocks have roared back to begin 2023. The tech-heavy Nasdaq Composite remains up nearly 12% in the new year, while the S&P 500 has gained 6.5%. The Dow Jones Industrial Average
DJIA,
+0.50%,
which outperformed its peers in 2022, is this year’s laggard, up just 2.2%.

So who’s buying? Individual investors have been relatively aggressive buyers since last summer before stocks put in their October lows, while options activity has tilted more towards buying calls as traders bet on a market rise, rather than playing defense through buying puts, said Mark Hackett, chief of investment research at Nationwide, in a phone interview.

See: Yes, retail investors are back, but they only have eyes for Tesla and AI right now.

Meanwhile, analysts say institutional investors came into the new year underweight equities, particularly in tech and related sectors, relative to their benchmarks after last year’s carnage. That’s created an element of “FOMO,” or fear of missing out, forcing them to play catch up and juicing the rally. Hedge funds have been forced to unwind short positions, also adding to the gains.

“What I think is key for the next move in the market is, do the institutions wreck the retail sentiment before the retail sentiment wrecks the institutional bearishness?” Hackett said. “And my bet is the institutions are going to look and say, ‘hey, I’m a couple hundred basis points behind my [benchmark] right now. I’ve got to catch up and being short in this market is just too painful.”

The past week, however, contained some unwelcome echoes of 2022. The Nasdaq led the way lower and Treasury yields backed up. The yield on the 2-year note
TMUBMUSD02Y,
4.510%,
which is particularly sensitive to expectations for Fed policy, rose to its highest level since November.

Options traders showed signs of hedging against the possibility of a near-term surge in market volatility.

Read: Traders brace for a blowup as cost of protection for U.S. stocks hits highest level since October

Meanwhile, the hot labor market underscored by the January jobs report, along with other signs of a resilient economy are stoking fears the Fed may more work to do than even its officials currently expect.

Some economists and strategists have begun to warn of a “no landing” scenario, in which the economy skirts a recession, or “hard landing,” or even a modest slowdown, or “soft landing.” While that sounds like a pleasant scenario, the fear is that it would require the Fed to hike rates even higher than policy makers currently expect.

“Interest rates need to go higher and that’s bad for tech, bad for growth [stocks] and bad for the Nasdaq,” Torsten Slok, chief economist and a partner at Apollo Global Management, told MarketWatch earlier this week.

Read: Top Wall St. economist says ‘no landing’ scenario could trigger another tech-led stock-market selloff

So far, however, stocks have largely held their own in the face of a backup in Treasury yields, noted Tom Essaye, founder of Sevens Report Research. That could change if the economic picture deteriorates or inflation rebounds.

Stocks have largely withstood the rise in yields because strong jobs data and other recent figures give investors confidence the economy can handle higher interest rates, he said. If the January jobs report proves to be a mirage or other data deteriorates, that could change.

And while market participants have moved expectations more in line with the Fed, policy makers haven’t moved the goal posts, he noted. They’re more hawkish than the market, but not more hawkish than they were in January. If inflation shows signs of a resurgence, then the notion that the market has factored in “peak hawkishness” go out the window.

Needless to say, there’s much attention being paid to Tuesday’s release of the January consumer-price index. Economists surveyed by The Wall Street Journal look for the CPI to show a 0.4% monthly rise, which would see the year-over-year rate fall to 6.2% from 6.5% in December after peaking at a roughly 40-year high of 9.1% last summer. The core rate, which strips out volatile food and energy prices, is seen slowing to 5.4% year-over-year from 5.7% in December.

“For stocks to remain buoyant in the face of rising rates, we need to see: 1) CPI not show a rebound in prices and 2) important economic readings show stability,” Essaye said. “If we get the opposite, we need to prep for more volatility.”