Last quarter, we wondered if the current level of interest rates was high enough to slow the economy. It seems we have our answer. The new jobs number, rightly or wrongly, is the most important monthly economic release. A few days after the latest Federal Reserve meeting, when policy members decided against increasing interest rates, the jobs created number came in worse than expected. This news sent market-based interest rates down to their lowest level since the spring of 2023.
At the same time, Japan surprised investors by increasing interest rates. This caused the Japanese Yen to rally against the dollar, reversing a multi-year trend of Yen weakness that had persisted since January of 2021. Large global investors borrowed in Yen due to the low Japanese interest rates then took the Yen and invested in other global assets–primarily U.S. stocks and bonds. This is called a “carry trade.”
The strategy works as long as the currency in which the investor borrows is stable or declining. The surprise increase in Japanese interest rates, and the subsequent rally in the Yen effectively blew up this popular trade. Investors who had loaded up on this strategy were forced to sell U.S. stocks to pay back the Yen denominated loans. The S&P 500 dropped 8% in about three weeks. This is a sign of forced portfolio adjustments and not a reflection of any change in economic fundamentals.
The Japanese stock market went haywire, enduring several 10% moves over the last couple weeks. The weaker than expected U.S. employment number suggests an additional one or two interest rate cuts. This leads to a weaker dollar. Then, the surprise interest rate increase in Japan caused the Yen to increase. When these short-term, “technical” moves occur the rebound tends to be just as quick as the sell-off recovery.
The following chart gives an indication of how much traders had bet against the Yen, and how much they’ve reduced their exposure since the trade began to work against them. This gives us a sense that most of the market reaction is behind us. In just the last week, it has recovered about half of its losses. I would not be at all surprised if the stock market is back to an all-time high by the end of the third quarter.
These brief volatility shocks remind us that there are all different types of investors that share one stock market. Commercial traders use massive amounts of leverage to squeeze out a marginal return. When the markets turn against them, they have to sell, or they will lose everything. Individual investors, who don’t use leverage, and who have an asset allocation appropriate to their time horizon, should be able to sell on their own terms. The key is not letting market volatility force you to do something that is against your own interest.
The recent volatility may have caused some investors to lose sight of the fact that the market is up 12% year to date. At the beginning of the year, we forecast that the S&P 500 would be worth about 5,500 at the end of 2024. Since then, earnings estimates have increased slightly. The performance of the market is exceeding our expectations, and many Wall Street firms are now forecasting that the S&P 500 will end the year somewhere around 6,000. The S&P 500 peaked at 5,667 a few weeks ago.
We also forecast that the 2024 returns would be strongest in the first part of the year. As we moved towards the election in November, the market would likely have to endure higher than average volatility. Once a presidential election is over, the market generally rallies through the end of the year. So, we were likely due for a little turbulence after what has been a smoother ascent than normal through the first half of 2024.
If we take a step back from all the short-term noise in the market, we find that the U.S. economy is in relatively good shape, especially compared to other developed economies. The annual rate of inflation continues to fall towards the long-term ideal of two percent. The economy is expected to grow about 3% in the current quarter—not too hot, not too cold, and unemployment remains low, below 5%. So far, it looks like the economy is set to land “softly.” A soft landing should allow corporate earnings to continue to move higher.
The general consensus is that the Federal Reserve will lower interest rates at least two to three times this year. This will support the earnings growth outlook for 2025. Falling interest rates should also put a floor under market valuations.
Analysts are coming out with their preliminary earnings estimates for 2026. More than a year away, these estimates are better described as educated guesses, but they give us a starting point for estimating where the S&P 500 will be at the end of next year. The early consensus is that the S&P 500 will reach $300 in earnings in 2026. If we assume that the market remains at twenty times earnings, the S&P should get to 6,000 at some point before the end of 2025. With dividends, the market should increase by about fifteen percent over the eighteen months.
Despite all of the twists and turns that the world will throw at us over the next year, I expect the market to continue to do what it has always done—be the greatest wealth generator for all kinds of investors.
