Morgan Stanley’s Mike Wilson warned that the stock market’s January rally could end this week with Federal Reserve officials expected on Wednesday to raise their benchmark federal funds rate for the eighth consecutive time.
Analysts seemed surprised at the good start for the U.S. stock market in 2023, saying in a Jan. 30 note that the rally is likely to fade based on month-end rebalancing and the upcoming Federal Open Market Committee (FOMC) meeting, whose 12 members determine monetary policy.
This could facilitate the start of a new leg lower in equities.
Wilson and his team said they saw the rally as “just another bear-market trap” with “all the good news” “now priced … the reality is likely to return with month-end, and the Fed’s resolve to tame inflation,” they wrote.
When interest rates rise, stocks tend to fall in value because of lower future earnings.
“Investors seem to have forgotten the cardinal rule of ‘Don’t Fight the Fed’” the analysts wrote. “Perhaps this week will serve as a reminder.”
“Don’t Fight the Fed” essentially means different market conditions require different investment strategies, according to the U.S. Gold Bureau. “Since the Fed controls the boom and busts of economic cycles and long-term interest rates … the idea is to position your investment strategy and portfolio allocation in alignment with Fed policies.”
Investors flocking to the equity rally will be disappointed, the strategists said.
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“Better price action in stocks has started to convince many investors they are missing something — compelling them to participate more actively. We think the recent price action is more a reflection of the seasonal January effect and short covering after a tough end to December and a brutal year.”
In reality, earnings are worse than expected, they said.
Even amid signs of a slowdown, investors are rewarding companies that exceed expectations and dialing back the punishment of those that fall short, Bloomberg reported.
Investors should sell the rally even if markets keep moving higher, strategists at JPMorgan Chase & Co. said in a separate note on Monday. Fundamental confirmation for the next leg higher might not come, and weaker earnings and activity could weigh on equities, a team led by Mislav Matejka wrote.
Last week, JP Morgan chief global markets strategist Marko Kolanovic said the economy is headed for a downturn as stocks rally, setting up for a selloff. He said he expects a recession in the U.S. and Europe as interest rates rise and consumers become less resilient.
The “January Effect” is a seasonal tendency for small-cap stocks to rally in the month after December’s tax-loss harvesting in generally illiquid equities. Theoretically, investors could use those funds to rebuy new positions in January, which can contribute to the monthly rally, according to Market Watch.
Earlier in January, Wilson, chief investment officer at Morgan Stanley, predicted that U.S. equities could slump another 22 percent.
The Fed is expected to raise rates by a quarter point on Feb. 1, after a half-point increase in December and four 75-basis-point increases before that. Markets overwhelmingly expect another quarter-point hike in late March to a 4.75-to-5 percent range, Investors.com reported. But some investors are betting policymakers will hold steady.