Evening Brief – 03.07.24

Ignore Tail Risks

It’s not difficult to uncover negative factors that can affect risk assets, but it’s rare to find so many of them. A trifecta of geopolitical (Middle East), economic (China’s struggles), and political (U.S presidential election) factors are top of mind for many investors.

The equities markets, depending on which metric one wishes to view, are overbought (some would argue we are in “bubble” territory), particularly with artificial intelligence stocks. These stocks have propelled the S&P 500 to multiple new all-time highs in recent weeks. Meanwhile, corporate default rates are increasing, with lower-than-average recovery rates.

Kenneth Rogoff, professor of economics and public policy at Harvard University, is perplexed by the stock market’s recent performance. “Given the challenges and uncertainties facing both the U.S. and global economies, it is difficult to see how the current stock market boom can last,” he recently wrote in the Guardian.

It may be tough to make a fundamental argument for stocks from the above perspective, but the factors influencing short-term market movements often go beyond fundamental analysis, involving elements such as investor sentiment, technical indicators and external events.

Money must go somewhere, and markets can defy expectations for far longer than the average investor’s tolerance. Furthermore, the relative impact of potential threats has a considerably lower impact on markets versus one actual threat, which we currently are not witnessing.

Many investors have the financial capacity to remain in the markets until a definite crisis emerges. Moreover, overvalued markets and increasing default rates have occurred historically, often requiring a significant market event to unsettle investors and force them to make portfolio adjustments.

“The U.S. stock market doesn’t appear to be in a bubble,” Ray Dalio, founder of hedge fund titan Bridgewater Associates, recently said. Citing a multi-factor proprietary metric, “When I look at the U.S. stock market using these criteria (USA Equity Markets Bubble Gauge), it, and even some of the parts that have rallied the most and gotten media attention, doesn’t look very bubbly. The market as a whole is in mid-range (52nd percentile). These levels are not consistent with past bubbles.”

Despite potential tail risks, the economy remains the most important catalyst for the equity markets. Most data releases continue to indicate that the U.S. economy and consumers have been able to navigate the current period of elevated interest rates.

This means the Federal Reserve may need to cut interest rates less than previously projected. A strong and self-sustaining economy with less need for aggressive rate cuts could be positive for stocks.