Stocks Can Enjoy 5.6 Trillion Reasons for a Year-end Rally

Despite concerns over various economic factors such as inflation, a resurgence in oil prices, Federal Reserve hawkishness, and China's weakened growth, the S&P 500 is set to begin Friday's trading session just under 2% below its peak for 2023. This resilience in the face of economic challenges is quite remarkable. While the positive sentiment from well-received initial public offerings (IPOs) like Arm Holdings' ARM this week has contributed to this rally, it's noteworthy that it has occurred despite benchmark bond yields, which have recently been considered a market challenge, remaining near 16-year highs.

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A key indicator of why these historically high implied borrowing costs are not dampening market sentiment to the same degree can be found in the ICE BofAML MOVE index, which tracks expected volatility in Treasurys. This week, the MOVE index dropped to its lowest level in 18 months, half of the level it reached during the regional bank crisis in March.

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The more relaxed bond market environment is mirrored in the equities market, where the CBOE VIX, a measure of expected S&P 500 volatility, is trading below 13, approaching its lowest level since January 2020.

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While it's common to suggest that such calmness might be a sign of complacency, it often serves as a contrarian indicator. However, there are several compelling reasons why bullish sentiment should hold firm.

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Firstly, from a technical standpoint, the S&P 500 has recently climbed back above its 50-day moving average, providing support. Even after the recent rally, the 14-day relative strength index, a momentum indicator, stands at 56, comfortably below overbought territory.

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Secondly, the easing anxiety in the fixed income market, following the European Central Bank's "dovish hike," is seen as a positive sign for equities. Analysts like Tom Lee at Fundstrat suggest that the equity rally that followed the ECB's move bodes well for when the Federal Reserve signals the end of its tightening cycle. Historical parallels to 1982 are drawn, with the key takeaway being that equities reached all-time highs just 17 trading days after the then Fed Chairman Volcker considered "ending the inflation war."

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Thirdly, there is a fundamental microeconomic reason for optimism: corporate profits. Earnings forecasts have improved in recent months, and the S&P 500's aggregate third-quarter earnings per share is expected to rise by 0.5%. If this growth rate is realized, it will mark the first quarter of year-over-year earnings growth reported by the index since Q3 2022.

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Lastly, one of the essential prerequisites for a sustained bull market is financial firepower. This means having sufficient cash available to support the trend when new highs are achieved. Currently, money market funds hold a record $5.625 trillion, as indicated in the chart below from Stephen Suttmeier, technical research strategist at Bank of America. While investors favor cash, the 5% return on cash lags behind the year-to-date return for the S&P 500 of approximately 17%. Given this, it wouldn't be surprising to see investors put their cash to work, potentially fueling a rally into the year's end.

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