Stock Bulls Battle Fed and Win With Resolve That Shocks Skeptics

(Bloomberg) -- Another time-honored axiom is being put to the test in the post-pandemic stock market, the one that says don’t fight the Federal Reserve.

This week, anyway, optimism around everything from corporate earnings to Covid-19 counts and seasonal market trends put a muzzle on central bank-obsessed skeptics. The S&P 500 shook off the gloom of the last month to post a resoundingly up week, with reopening themes like automakers, raw-material producers and retailers posting the best gains.

The dip-buying reprisal was a shocker for investors who in the past month had pushed fund flows into stocks to a one-year low. It also caught Wall Street’s handicappers off guard. At Morgan Stanley, Mike Wilson pushed out his prediction for a peak-to-trough decline of at least 10% for the S&P 500 to early next year. In August, he saw it happening in the fall.

“It’s not been a good year for us on the level of the S&P 500, and we own that,” Wilson, the bank’s chief U.S. equity strategist, said in an interview with Jonathan Ferro on Bloomberg TV. “Where we’re ahead of ourselves is, in a mid-cycle transition, the market does gravitate to high-quality stocks. The reality is, the S&P 500 is the highest quality index in the world. We think it’s been delayed here.” 

Equity resilience was on display this week, with the S&P 500 climbing 1.8%, even as the minutes of the Fed’s last policy meeting and stronger-than-expected inflation data prompted bond traders to price in earlier rate hikes. Fed officials agreed broadly that they should start reducing emergency pandemic support for the economy in mid-November or mid-December, the minutes showed.

As has reliably been the case since the Covid outbreak in early 2020, corporate earnings served as an antidote in a market where everything from Fed taping to commodity inflation and China’s real estate woes is whipping up investor angst. Though early, among S&P 500 firms that reported quarterly results, 83% exceeded analysts’ profit estimates, a pace that before the pandemic was unprecedented.

Along the way, the S&P 500 rose back above its 50-day moving average of 4,437, a trendline watched by traders to determine near-term direction. The index also retraced 61.8% of its September decline, a milestone that according to Fibonacci analysis would herald a full recovery if it’s sustained. Its all-time high was 4,545.85 on Sept. 2. 

One concern: Friday’s monthly option expiration has the potential to spur bigger price swings in subsequent days. Since option dealers buy and sell underlying stocks to keep a neutral position, the need to hedge decreases once options mature. To Nomura Securities strategist Charlie McElligott, the rollover this time would see market makers’ equity exposure to the S&P 500 drop off by 35%, removing some pressure on the market to stay in a range. 

Goldman Sachs Group Inc. strategists including Vishal Vivek and John Marshall echoed the view, noting Friday’s expiration of $703 billion of single stock options was the third highest on recored outside January. Their study found that while the S&P 500’s volatility on expiry days this year has been consistent with pre-pandemic levels, the first day of trading after the monthly event was wilder, with the index swinging an average 1%, almost double the move in the 2012-2019 period. 

In other words, brace for some turbulence Monday.  

As stocks recovered from September’s worst monthly drop since March 2020, sentiment was largely mixed. The hand-over-fist buying sprees that put an end to past dips were missing. Inflows to equity funds over the past four weeks fell to the lowest level since October 2020, EPFR Global data compiled by Bank of America Corp. show.

But the heightened fear that forced option traders to load up on hedges during the summer months also dissipated. In fact, prices for calls slowly perked up, indicating demand for upside. 

Bulls have history on their side when it comes to the stock performance during the fourth quarter. Since 1927, the S&P 500 has notched gains in the final three months about 60% of the time. When the first nine months saw the index rising more than 10%, as was the case in 2021, the odds of positive returns jumped to 78%.

The seasonal pattern is one reason why Morgan Stanley’s Wilson reconsidered his correction call. Still, the strategist warned that analysts will have to cut their earnings estimates given supply-chain bottlenecks and the potential for a corporate tax hike. With stocks already trading at stretched valuations, downward profit revisions would lead to another round of selloff. 

“There will be a greater slowdown in growth next year from an earnings standpoint than what the consensus is modeling,” Wilson said. “That may take another three to four months to play out because in this window, companies can get a pass on supply constraints, and we have the seasonal strength in the near term. But I have not lost any confidence in the idea that the numbers are going to come down.” 

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