A breather in the market rally may be healthy and in-line with history

Some caution after a strong rally seems reasonable here

After a remarkably strong rally to start the year, markets have given back a bit in August thus far, with the S&P 500 down around 3% since its recent high on July 31. Underneath the surface, however, we see the Nasdaq is down over 4.0% during this period, and the "Magnificent 7" large-cap stocks are down over 6.0%. The parts of the market that have led the way higher are now perhaps taking a breather, which we view as a healthy development as investors digest outsized gains.

In our view, some caution is likely prudent after a nearly 18% rally in the S&P 500 and a 30% move higher in the Nasdaq from March through July*. Particularly as we head into August and September, which tend to be more volatile months in markets, we could see a more traditional correction in the 5% - 10% range emerge in markets. However, we don't see a correction derailing what we believe is the early stages of a longer-term bull market, particularly as many fundamentals around inflation, interest rates, and the economy continue to support a better backdrop for financial markets ahead.

The good news is that the market rally has been underpinned by better fundamentals

The market rally in its early stages was driven by enthusiasm around artificial intelligence (AI) and was led largely by mega-cap technology. More recently, however, the rally has broadened, with leadership coming from cyclical sectors and even rebounds in small-cap stocks and international equities. This occurred as markets climbed several walls of worry, particularly around inflation, the Federal Reserve and the broader economy:

• Inflation continues to trend in the right direction:?This past week, investors digested key inflation reports, including U.S. CPI (consumer price index) inflation for the month of July. CPI inflation was largely in line with the expectations, with headline CPI at 3.2% year-over-year, versus expectations of 3.3%*. Inflation did tick higher from last month's 3.0% reading, but this was largely expected given higher energy prices last month, as well as easier annual comparisons versus last July. Core inflation, excluding food and energy, came in at 4.7%, in line with expectations and below last month's 4.8%*. The shelter component, which makes up about 40% of the core CPI basket, continued to climb at the lowest monthly pace since its recent highs*. In our view, shelter inflation in the CPI basket should continue to ease in the months ahead, as lower shelter and rent prices are reflected in CPI with a lag impact. Of note, while last week's inflation data was moving in the right direction, the market reaction was largely muted, perhaps another sign that markets had priced in some of this good news already.
• The Fed could remain on hold for now:?After the relatively benign inflation data last week, markets continue to expect the Fed to remain on hold through 2023. In our view, this is a credible scenario, and, barring any inflation shocks, we would expect the Fed to hold the fed funds rate at the current 5.25% - 5.5% for an extended period. We would, however, expect the Fed to leave the door open to additional rate hikes if needed and message this consistently. But overall, the next move by the Fed, perhaps in the first or second quarter of 2024, could be a rate cut, particularly if inflation continues to head toward its target range.
• The economy is holding up better than expectations:?Perhaps the most notable shift in market and investor sentiment has been around better-than-expected economic growth. Markets seemed to have embraced the notion that the economy may avoid a recessionary period and could perhaps grow above-trend this year. Recent data has supported this view as well, with the Fed's own GDP-Now forecasting tool pointing to third-quarter U.S. GDP growth of a remarkable 4.1%. In our view, some form of a rolling downturn in the back half of 2023 and early 2024 could be likely, as parts of the economy may stabilize, like manufacturing and housing, while other parts may soften, like services sectors. Overall, while we may see a cooling in growth to below trend, we may avoid a traditional recession of consecutive quarters of negative economic growth.

Corrections after strong rallies typically average about -8.0%

History tells us that strong rallies in the S&P 500 are typically followed by some form of pullback or correction, but these may not be long-lasting. Since 1950, there have been 35 instances of the S&P 500 rallying over 15%. On average, there has been at least one pullback that follows in the six months after the rally. These pullbacks have varied from -2.5% to -19%, with an average of -8.2% and median of -7.6%. In all instances, markets recovered from these pullbacks in about six months on average. However, if we take out the three highest days to recovery, the average time to recover from a pullback falls to just 46 days, or about 1.5 months. In our view, we don't see a fundamental driver for a deep or prolonged pullback, and we would expect a correction, if it occurs, to be largely in line with the averages we've seen historically.

What might drive the next leg higher?

Overall, markets have priced in a lot of good news, including better inflation trends, a potential pause in Fed rate hikes, and an economy that continues to grow above-trend . The question now may be, What is the catalyst that drives markets higher from here? We believe there may be three potential factors to consider:

• First, we believe a market correction would be healthy and allow markets to digest recent gains and then reset for a potential move higher.
• Second, we believe the earnings picture will gradually start to improve in the second half of the year and through 2024. While second-quarter S&P 500 earnings are likely to be around -5.0% year-over-year – the third straight quarter of negative earnings growth – the back half of the year is expected to be positive, and 2024 earnings growth could head toward double-digits. Markets should welcome this renewed strength in earnings growth.
• And finally, the path of the Federal Reserve may serve as a potential catalyst next year as well. While our view is that the Fed is likely to remain on an extended pause through 2023, it may signal potential rate cuts in 2024, which may be viewed as positive by markets, particularly if inflation has moved closer to the 2.0% target.

Where are the opportunities if we do get a pullback in markets?

For those investors that didn't fully participate in the rapid rally that occurred in the first half of the year, a pullback or correction may be welcome and could offer an opportunity to add quality investments at better prices. We continue to see compelling long-term opportunities in both equities and bonds in the months ahead.

In equities:?We would look for broader participation, particularly as investors look toward 2024, which we think could bring lower inflation, lower interest rates and better earnings trends. Leadership could include small-cap stocks; cyclical sectors, like industrials, materials and consumer discretionary; and international equities, alongside artificial intelligence (AI) and technology.

In bonds:?Finally, we see an opportunity to complement some positioning in short-duration bonds and cash-like instruments with longer-duration bonds, particularly in the investment-grade space. With Treasury yields pushing toward highs recently, this could present interesting entry points in the months ahead. We believe investments in longer-duration assets could not only capture better yields, but also have the potential for price appreciation, as the Fed pauses and ultimately pivots lower.

Read more in our Weekly Market Wrap here: https://www.edwardjones.com/us-en/market-news-insights/stock-market-news/stock-market-weekly-update

Sources: *FactSet