Do Not Be Fooled by the Stock Market's Best Week of 2024

Stocks have made a dramatic comeback from the rough start they experienced in August, which marked the worst beginning to the month since 2002. However, this rebound should not overshadow a significant shift in how the markets are now interpreting economic data.

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Tony Roth, chief investment officer at Wilmington Trust Investment Advisers, explained in a recent interview that the markets are at a critical turning point. He noted that investors are recognizing two key developments: first, that inflation is stabilizing, and second, that the economy is slowing down. While progress on inflation is positive news, as it could pave the way for the Federal Reserve to start cutting interest rates, the focus has now shifted to concerns about economic growth. Investors are increasingly worried that the much-anticipated economic "soft landing" could instead turn into a recession.

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This shift in focus means that the market is moving from being concerned about inflation to being concerned about growth, Roth explained. Wilmington Trust predicts that U.S. gross domestic product (GDP) growth will slow to an annual rate of 1.5% in 2025. They also warn that there is a one-in-three chance that the economy could slip into a recession.

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Roth highlighted that the market is entering a new phase of volatility, different from what has been seen in the past. The margin for error is smaller, meaning that any missteps could have significant consequences.

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Recently, the market's response to economic news has become more straightforward: bad news is now bad for stocks, and good news is good for stocks. This is a change from the previous pattern, where bad news could sometimes lift stocks by increasing the likelihood of a Fed rate cut, while good news could dampen the market by reducing that possibility.

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This shift became evident on August 2, when a slightly weaker-than-expected July jobs report triggered a stock market selloff. The selloff was exacerbated by the unwinding of the popular Japanese yen carry trade, leading to concerns that the Fed might have made a policy mistake by keeping rates unchanged at its July meeting. For a brief period, traders even priced in the possibility of an emergency rate cut in August and increased their bets on a 50-basis-point cut at the Fed's September meeting.

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However, better-than-expected weekly jobless claims reports and other positive economic data helped stocks recover. As fears of an imminent economic downturn eased, traders adjusted their expectations, now anticipating a quarter-point rate cut in September, followed by similar cuts in November and December. Meanwhile, Fed Chair Jerome Powell's upcoming speech at the annual economic symposium in Jackson Hole, Wyoming, is expected to attract significant attention.

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The first half of August was particularly tumultuous. On August 5, the S&P 500 dropped 3%, and the Dow Jones Industrial Average fell by more than 1,000 points. This marked the worst three-day start to any month for the S&P 500 and the Nasdaq Composite since August 2002.

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But August 5 appeared to be the turning point. Stocks stabilized, and by the following Friday, the S&P 500 had extended its winning streak to seven sessions. The S&P 500, Dow, and Nasdaq all posted their strongest weekly gains since November, according to Dow Jones Market Data. At the same time, the Cboe Volatility Index, Wall Street's "fear gauge," dropped back below its long-term average, indicating reduced expected volatility.

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Nicholas Colas, co-founder of DataTrek Research, observed that July represented peak optimism about a U.S. soft landing, while August has seen one of the sharpest, albeit brief, growth scares in over 30 years on Wall Street.

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Despite the initial turmoil, investors have expressed relief. The unwind of the yen carry trade, which initially caused concern, did not lead to major systemic issues as hedge funds and other traders were forced to rapidly unwind positions. Mark Dowding, BlueBay chief investment officer at RBC Global Asset Management, noted that markets are now in better shape, even if they have been battered and bruised.

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However, Dowding cautioned that economic growth is likely to maintain its momentum, which could mean that investors' hopes for significant rate cuts may be disappointed.

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Wilmington Trust's Roth suggested that further "growth scares" are likely, meaning that sustained periods of low volatility are unlikely to return. Nonetheless, the conditions for a continued stock-market rally remain in place. Labor data, in particular, has taken center stage as the most critical market driver, surpassing inflation in importance.

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Colas also anticipates a bumpier ride ahead. He expects another growth scare before the end of the third quarter, which could lead to continued outperformance by defensive sectors in the near term. However, he sees the potential for a strong rally led by growth stocks as we move into the end of 2024.

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