After breathtaking surge, US stocks' path may rest on economic soft landing

By Lewis Krauskopf

NEW YORK (Reuters) - Are U.S. stocks poised to continue their dramatic run, or is a pause ahead? That’s the question investors are asking as the S&P 500 heads into the close of the year with fresh highs coming into view.

Signs of cooling inflation have fueled hopes that the Federal Reserve is done raising interest rates, helping extend a rally that has seen the S&P 500 gain over 9% since late October. The index is now up nearly 18% for the year and less than 2% away from its year-high, reached in July. Its record closing level, from January 2022, is some 6% away.

Whether it can reach those levels in coming weeks depends in-part on how convinced investors are that the U.S. economy is on track for a so-called soft landing, where the Fed brings down inflation without badly damaging growth. So far, the economy has proven resilient in the face of tighter monetary policy, though some measures of employment and consumer demand have softened.

Rising valuations and still-elevated Treasury yields pose another obstacle. Other factors, however, including historical seasonal trends, could support more gains.

“We have this balance right now between a lower inflation outlook and a better interest rate trajectory ... juxtaposed against a slowing economy,” said Yung-Yu Ma, chief investment officer at BMO Wealth Management.

Investor optimism on equities has grown over the last few weeks, as markets rebounded from a months-long drop that ran from August through much of October. Stock exposure by active investment managers has shot to its highest level since August, from a one-year low hit last month, the National Association of Active Investment Managers exposure index showed.

U.S. equity funds drew about $9.33 billion in net inflows in the week to Nov. 15, the largest weekly net purchase since Sept. 13, according to LSEG data.

Treasury yields, whose steady rise over the last few months has weighed on stocks, have rapidly retreated: the benchmark 10-year Treasury yield stood at 4.43% early Friday, from a 16-year high of just above 5% last month. Yields move inversely to bond prices.

Analysts at Ned Davis Research, which has been recommending an overweight to stocks, this week said investors should further shift into equities and away from bonds. A key factor: softer-than-expected consumer price data for October, released earlier this week, makes it unlikely that the Fed will need to raise rates further.

“Investors have been grappling with whether the Fed can pull off a soft landing,” wrote Ed Clissold, chief U.S. strategist at Ned Davis Research. “The CPI report ... supports the case that the tightening cycle is over, and that the higher-for-longer mantra may not be as long as previously feared.”

Robert Pavlik, senior portfolio manager at Dakota Wealth, said a number of investor concerns have fallen away, including worries over a third-quarter earnings season that turned out better than expected.

"Both retail and institutional portfolio managers are going to realize that stocks are the best place to be between now and year-end," said Pavlik, who is "fully invested" in his equity portfolios.

Seasonality is also in stocks' favor: November and December have posted the year's second- and third-biggest monthly returns since 1950, rising 1.5% and 1.4% on average, according to the Stock Trader's Almanac.

Equities face a number of tests next week. Chip heavyweight Nvidia reports quarterly results on Tuesday, the last report this earnings season from the "Magnificent Seven" megacap companies, whose massive share price gains led equity indexes higher this year.

The health of the consumer-driven economy comes into view with Black Friday, the day after Thanksgiving that is the traditional start of U.S. holiday shopping. Data on Wednesday showed U.S. retail sales fell for the first time in seven months in October.

One source of worry has been a renewed climb in stocks' valuations. The S&P 500 trades at 18.7 times forward 12-months earnings estimates, a roughly two-month high and well above its long-term average of 15.6, according to LSEG Datastream.

Jason Pride, chief of investment strategy and research at Glenmede, said his firm is underweight equities and has larger than normal allocations to cash and short-term fixed income.

"Rates are still high enough, financial conditions are still tight enough that the near-term horizon ... is troubling and probably doesn’t justify the high level of valuations,” he said.

The recent surge in stocks means "the bar for positive surprises is also higher," according to Keith Lerner, co-chief investment officer at Truist Advisory Services, who recommends adding to equity positions on pullbacks.

“It would be perfectly normal for stocks to take a breather here," he said.

(Reporting by Lewis Krauskopf; Editing by Ira Iosebashvili and Nick Zieminski)