The $4 Trillion Stock Rally is at Stake as the Decisive Moment Arrives

Investors are bracing for a pivotal week as two significant events—the release of a key inflation measure on Tuesday and the Federal Reserve's interest-rate decision on Wednesday—are anticipated to shape the trajectory of the stock market and the economy heading into 2024.

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Speculation is mounting that the Federal Reserve, having concluded its rate-hiking cycle, will commence rate cuts by mid-year. This speculation is contributing to a notable decline in Treasury yields, reigniting investors' risk appetite. Since late October, the S&P 500 Index has surged, adding approximately $4 trillion in market value. Investors are redirecting their focus towards previously neglected sectors like small caps, which traditionally benefit from declining borrowing costs.

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Chris Zaccarelli, Chief Investment Officer at Independent Advisor Alliance, observes that the optimism surrounding the Federal Reserve's apparent cessation of rate hikes has been a driving force behind the stock market rally. He notes that this optimism aligns with the substantial drop in 10-year yields since mid-October, suggesting a continued upward trajectory for stocks as we approach 2024.

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However, a closer examination reveals concerns for the upcoming week. The anticipated volatility in the S&P 500 over the next five trading sessions is surging compared to the subsequent five days, signaling an increased demand for hedging against potential turbulence. This volatility, reaching its widest point since March for this specific period, underscores the caution among investors.

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The crucial moments begin on Tuesday with the release of November's consumer price index, a significant factor in shaping market expectations. A potential decrease in inflation could provide a year-end boost to shares by reinforcing the belief that the Federal Reserve will pivot towards easing. According to a Bloomberg survey, consumer prices are expected to have risen at a 3.1% annual pace, the lowest since June.

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The following day, the Federal Reserve is anticipated to maintain its policy for the third consecutive meeting. Traders, expecting approximately a percentage point of total easing in the coming year, will closely scrutinize rate projections and Chair Jerome Powell's press conference for insights into the central bank's stance.

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A potential risk looms if a robust economy sustains high inflation, prompting officials to contemplate further rate hikes or an extended period of elevated borrowing costs. This scenario could adversely affect rate-sensitive tech stocks, which have been primary drivers of the market's gains in 2023.

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Chris Zaccarelli emphasizes the significance of Chair Powell's statements, suggesting that an unexpectedly hawkish tone could alter market perceptions. Despite these potential challenges, the S&P 500 has recorded an almost 20% gain this year, closing on Friday at its highest level since March 2022.

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Investors are banking on the hypothesis that as bond yields continue to trend lower, stocks are poised for widespread gains heading into year-end. Since October 19, the yield on 10-year Treasuries has fallen from nearly 5% to around 4.2%, coinciding with an almost 8% rise in the S&P 500.

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Analyzing historical data, it is evident that substantial drops in bond yields have historically been beneficial for the stock market. Instances where 10-year Treasury yields fell by 50 basis points or more within a month have resulted in median subsequent forward three-month returns of nearly 8% for the S&P 500 and 8.2% for the Russell 2000.

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Retail investors are actively participating in this optimism, with data indicating a significant weekly inflow of $6.8 billion into U.S. stocks. This surge is the largest since March 2022 when the Federal Reserve initiated its tightening cycle. Simultaneously, many active managers, seeking to recover lost ground, are contributing to the momentum in the stock market.

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Vincent Deluard, Director of Global Macro Strategy at StoneX, notes that numerous investors misjudged the macroeconomic landscape in 2023, expecting a recession. The challenges faced by active managers in navigating this unexpected environment have resulted in a difficult year, with only 41% of large-cap active funds beating their benchmark in last month's rally, according to data from Bank of America Corp. In summary, the coming week holds significant implications for investors as they navigate the intricate dynamics of inflation, Federal Reserve decisions, and market volatility.