Equities closed out a volatile August on a high note, with each of the three major indices recording gains for the week and full month. Positive returns for the month are noteworthy given the sharp sell-off of equities during the first week of August, when investors grappled with weaker than expected jobs data, which fed fears of a looming recession. Since then, economic headlines have largely been seen as bullish even as details have offered cause for caution. Indeed, the latest results from the Association of Individual Investors (AAII) Sentiment Survey shows that the portion of investors who are bullish has climbed 10.7 percentage points since the first week of August to a historically elevated 51.2 after last week’s 51.6. Likewise, bearish sentiment has tumbled from 37.5 on August 7 down to just 27 as of last week. For context, going back to the inception of the survey in 1987, the historical average bullish reading is 37.6 percent. Interestingly, this level of bullishness has often served as a contrarian indicator. In the 179 weeks going back to 1988, when the bullish outlook has been at current levels or higher, the S&P 500 posted negative returns 31.3 percent of the time. Overall, the average one-year return when bullish readings are at current levels or higher is just 3.83 percent. By comparison, one-year forward returns for the S&P 500 from any given Friday regardless of bullish readings is 17.7 percent.
This reality combined with elevated valuations and an economy that appears late in the growth cycle explains our nearer-term caution. However, we again note there are opportunities in other parts of the market, such as some Small and Mid-Caps that we believe are cheap and have been overlooked.
The levels of optimism and conviction have helped push equities to new highs as investors increasingly see expected rate cuts later this month as the antidote to signs that the labor market is weakening and could pose a threat to future economic growth. What’s striking is that, judging by the minutes of the most recent meeting of the Federal Reserve, policymakers seem less certain. While there is clearly a consensus that the Fed should cut rates, the assessment from members of the Federal Open Market Committee acknowledged that risks persist for both sides of the Fed’s dual mandate of price stability and maximum employment. “Some participants noted that as conditions in the labor market have eased, the risk had increased that continued easing could transition to a more serious deterioration.” In other words, softness in the labor market could gain momentum, leading to layoffs. At the same time, “a few participants noted that an easing of financial conditions could boost economic activity and present an upside risk to economic growth and inflation.”
The soft landing has rightfully gained steam in the past few weeks as the pace of inflation slowed, and the economic growth appears to be holding up. However, given growing signs of weakness in the labor market, we don’t yet believe the economy is out of the woods. Additionally, as we saw in the fourth quarter of 2023, inflation was slowing (as it is today) but then reversed course and moved higher during the first four months of this year as expectations of rate cuts led to loosening financial conditions and may have sparked the rise in price pressures. While it is possible that the Fed threads the needle between the two risks encompassed by its dual focus, we believe it is far from certain. And given the rich valuations we highlighted in last week’s commentary, we believe investors would be well served by following an investment plan for which an unexpected twist or turn doesn’t have an outsized impact on the long-term success of achieving their financial goals.
About the Author:
Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.
