The Federal Reserve is expected to announce its monetary policy decision on Wednesday, and the market is buzzing with anticipation. Investors are hoping for a series of interest-rate cuts from the Fed. However, if the central bank disappoints, many stocks might falter.
Bond Yields on a Decline
One of the notable indicators is the drop in bond yields. The two-year Treasury yield has decreased to 4.3%, down from its peak of roughly 5.2% in October. This decline in yields suggests that the bond market is forecasting a start to rate cuts in March, as inflation subsides. Lower rates have the potential to stimulate economic growth.
Stocks Benefit from Bond Yield Dip
This decrease in bond yields has been beneficial for stocks. The Invesco S&P 500 Equal Weight exchange-traded fund (ETF) has climbed approximately 19% to $158 from its multi-month low point in October. The unique feature of this ETF is that it assigns equal weight to each stock in the index, removing the influence of industry giants like Apple, Amazon, and Meta Platforms. Coincidentally, these companies are expected to announce their quarterly earnings this week.
High Expectations Built In
The equal-weighted S&P 500 already reflects the market’s high expectations for changes in Fed policy. Similar to the conventional S&P 500, the individual stocks within the ETF have experienced significant gains. However, if the Fed fails to signal the desired number of rate cuts, these stocks could experience a drop. This is especially concerning since inflation still hovers slightly above the Fed’s target of 2%.
The Fed’s Stance and Its Impact on the Market
The Federal Reserve’s position on rate cuts in 2024 has drawn both attention and speculation from market analysts. While some anticipate only two or three rate cuts, others believe a cut may be proposed as early as March. However, this difference in expectations could lead to significant market reactions.
Tom Essaye of Sevens Report highlights the importance of the Fed’s statement. He argues that if the Fed is genuinely committed to a limited number of rate cuts, it should firmly discourage the idea of a cut in March. Essaye predicts that such a statement would likely result in a substantial decline in the market.
The anticipation of a rate cut has contributed to some stocks reaching their resistance level, where investors tend to sell and subsequently drive prices down. For instance, an ETF reached its peak at approximately $162 in late 2021 but has consistently failed to surpass the high $150s. Breaking through this resistance requires a transformative change, such as the Fed taking aggressive measures to lower rates. Should this validation be absent, stocks will face considerable challenges in the coming week.
It is important to note that approaching this situation leaves little room for a middle ground. Stocks currently have elevated valuations, and there is an excessive degree of optimism surrounding potential rate cuts. This combination exposes the market to downside risks, even with minor disappointments.
Comparing the ETF’s current valuation to analyst earnings estimates for the next year, it appears to be trading at a discount. While the standard S&P 500 trades at 20.2 times earnings estimates, the ETF is valued at 16.2 times estimates. However, it is worth mentioning that the equal-weighted index has traded at levels as low as 13 times in recent months. Consequently, if the market begins to anticipate less favorable conditions for rates and the economy, the ETF’s multiple could decline further.
In light of these factors, it is crucial to brace for potential market downturns as investors digest the Federal Reserve’s statement. This impending development will undoubtedly shape market sentiment and drive investment decisions.