Is the equity market starting to listen to the FED? Or are investors cautious after such an extensive rally?

US indexes finished the week lower. The Nasdaq ended an 8-week winning streak, while the S and P 500 ended a 5-week winning streak. The Dow Jones Industrial Average also finished a winning streak of 3 weeks. Are we simply seeing a pullback after an extensive rally? Is there more behind it?

Top 3 stocks

Before we move on to the cause of the sell-off on Friday's trading day, let us examine three interesting stocks that caught my eye. According to the Wall Street Journal, 3M agreed to pay up to 12.5 billion dollars to settle a lawsuit that claims that "forever chemicals" created by 3M contaminated drinking water. The stock finished slightly in the green by 0.29% at 100.72.

Siemens withdrew its guidance for fiscal-year profit. The company stated on Friday that fixing issues related to wind-turbine component failures could cost $1.1 billion. Shares of Siemens Energy finished the trading day down by 26.99% at 15.88.

CarMax reported earnings that beat expectations. Analysts expected EPS of 79 cents. The company reported EPS of $1.44. Shares of CarMax finished the trading day up by 10.07% at 86.21.

The equity market is starting to listen to the FED.

One must acknowledge that stocks have gone through tough times since the interest rate hike cycle started. However, the strength of the US economy continues to surprise investors. Combine this with falling inflation, and it makes sense that equities have rallied. Because the rally has been so significant, it makes sense that investors are taking profits home in an environment where we still face much macroeconomic uncertainty. However, there is more to it. In the previous FOMC meeting, the FED decided to keep interest rates unchanged between 5% and 5.25%. Even though the dot plot indicates that the federal funds rate could rise to 5.6% by the end of 2023, the equity market rallied as J Powell held his press conference. The reason for this is that, at first, the equity market interpreted the latest FOMC meeting as the FED reaching a terminal rate. Hence, investors expected the FED to stand on the sidelines. The equity market also knew that hiking interest rates after a pause is, historically speaking, very unlikely. The belief that a terminal rate has been reached faded slightly during this week. As J Powell talked in front of the House, he reiterated that the economy remains strong, demand for labor remains above supply, and there is a long way to go before reaching price stability. Powell also stated that nearly all FOMC members find raising rates further in 2023 appropriate. Even though J Powell has said this before, markets seem to start listening to the FED, as the likelihood for interest rate cuts this year become more unlikely due to sticky inflation and a resilient economy. If the FED stays hawkish, the equity market will price out some of the rate cuts that are still being priced in, and higher treasury yields would make investing in equities less attractive. This trend has contributed to today's declines.

My theory is that the interpretation of economic data will become very interesting. My hypothesis states that weak economic data will cause more pessimism than strong economic data will cause optimism. I have two reasons for this interpretation;

1. As markets realize that the FED is more hawkish than was previously anticipated, it will become less likely that, once we see economic weakness in the broader economy, the FED will step in for the rescue by cutting rates. The FED is committed to restoring price stability, the highest priority.
2. We continue to push out our anticipation of a potential recession. However, we still expect it to happen. The 2s/10s is now at around -100 basis points, and we have yet to feel the impact of 500 basis points of rate hikes on the real economy. However, because most still anticipate a recession, once the economic data starts to reflect a downward trend of the economy more clearly, a sell-off could?result in the equity market.

Generally speaking, real rates could be considered too low for the economy to fall into a recession. Using the inflation-protected treasury yields, we have a real rate of 1.4%, which is only slightly above the neutral rate of the FED, which is at 0.5%. As we continue to see a strong economy, especially strength in the rate-insensitive service sector, I expect inflation to go sideways. In this so-called "no landing" scenario, stocks can perform well. However, there will be downward pressure on equities because the FED will likely raise rates again in this scenario, and rising treasury yield would make investing in equities less attractive.

Economic Data

S and P Global Composite PMI was released on Friday. It fell to 53 from 54.3 in May. Markets expected an increase to 54.4. The S and P Global Manufacturing PMI remain in contraction territory at 46.3. Chris Williamson, Chief Business Economist at S&P Global Market Intelligence, believes that the S and P Global Composite PMI aligns with GDP growth of around 1.7% in Q2 2023. After the report, US treasuries edged lower as investors bought treasuries, and stocks continued their decline.

Other economic data released throughout the week were US housing starts which rose to a 13-Month high due to a lack of supply of existing homes on the market and still relatively high demand. At the same time, US home resales fell -20.4% in May compared to a year earlier. Existing home sales rose 0.2%. US existing home prices fell by the most significant amount annually in more than 11 years. $396,100 is the median sales price which is 3.1% lower compared to a year ago. Overall, we see unexpected strength in the housing sector, which is sensitive to rate hikes. However, the sector remains under pressure due to significantly higher mortgage rates caused by higher interest rates. Jobless claims released on Thursday held steady at a 20-month high, at 264,000.

Market Performance.

The S&P 500 Index was down 0.8% at 4,348.33, the?Dow Jones industrial average?was down 0.7%, and the Nasdaq Composite was down 1.0% at 13,492.52.

The?10-year Treasury yield was down about six basis points at 3.737, and Cboe's VIX Volatility Index?was up 0.47 at 13.39.