After a long absence, volatility is finally returning to the stock market.
The S&P 500 is a little over 3% off the high, while the Nasdaq Composite has dropped by 5%. Those declines are still modest.
But the pullback in some of the market’s biggest winners is growing more noticeable.
That includes Palantir (PLTR), which has shed 17% in just four trading sessions. Robinhood (HOOD) is nearly 19% off the high from October. Even Nvidia (NVDA) isn’t immune to the pullback. It’s down 13% in a week.
More speculative areas of the market are starting to get hit hard.
And there’s one important reason why…
Easy money has played a big role in driving stock prices higher. And now it is emerging as a headwind for the rally.
So today, let’s look at what could finally pour cold water on the market’s incredible rally…
But before we turn to that, if you enjoy this e-letter, I’d be very grateful if you recommended it to a friend. You can click here to forward it. Thank you!
The Federal Reserve has cut interest rates by a quarter point at two consecutive meetings.
But now Fed Chair Jerome Powell choked investors’ hopes for additional rate cuts.
Last month, Powell commented that a “further reduction in the policy rate at the December meeting is not a forgone conclusion.”
And Powell’s hardly the only Fed member to voice concerns about cutting rates again. Other central bank officials are sounding the alarm on additional cuts as well.
Fed Vice Chair Philip Jefferson said recently it “makes sense to proceed slowly as we approach the neutral rate.”
Other officials shared similar messages, and that’s shifting the outlook for additional rate cuts.
Near the end of October, market odds for a cut at the December meeting were running over 95%. Now those odds have recently dropped as low as 62%.
And it’s not just the December meeting that’s suddenly in question.
The entire rate-cutting cycle could be over just as quickly as it began.
Here’s why that could spell bad news for the rally…
For clues on what lies ahead for the short-term fed funds rate, pay close attention to the 2-year Treasury yield.
The 2-year yield tends to lead changes in the fed funds rate. Here’s a chart comparing the two:
Source: Bloomberg
You can see when the Fed started raising the fed funds rate (orange line) in 2022. Yet the 2-year yield (blue line) was already surging ahead at “1.”
Then the 2-year yield dropped below fed funds back in March 2023 at “2,” which flagged the easing cycle now underway.
So look at what’s happening now at the arrow.
Fed funds and the 2-year yield are converging at the same level. That is the market’s way of suggesting that the Fed could cut once more… and then be on hold.
And that rate outlook could come back to bite investors…
Falling interest rates make future profits worth more in today’s terms, and vice versa.
Growth stocks’ earnings potential is often way off in the future. So their valuations are even more susceptible to interest rate changes.
That’s why the prospect of more rate cuts was boosting the market in general… particularly in speculative growth stocks.
But areas of the market with excessive valuations, including technology and growth stocks, are the most exposed to a less-friendly rate outlook.
These are the very stocks propping up the market.
So if a shifting rate outlook causes investors to rethink valuations, there could be much more downside waiting for investors.
Happy Trading,
Larry Benedict
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