Don’t buy the stock market rally? smart money makes

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Like the good old times. That’s what it must look like with the S&P 500 index up about 15% since mid-June and poised for its fourth straight weekly gain, its longest winning streak of the year. Those who question the sustainability of this rally, given the slowing economy and a Federal Reserve that has doubled down on its plan to keep raising interest rates, can take comfort in one key metric: the smart money.

This can be seen in the Smart Money Flow Index, which measures action in the narrower Dow Jones Industrial Average during the first half hour and last hour of trading. The idea is that the first 30 minutes represent emotional buying, driven by greed and fear of the crowd based on good and bad news, as well as lots of buying on market orders and short hedging. Institutional “smart money” investors, however, wait until after trading to place big bets when there is less “noise”.

That gauge hit its highest level in two years, when animal spirits ruled Wall Street and the S&P 500 surged above its pre-pandemic highs, sparking one of the strongest bull markets in history. Few are anticipating a repeat performance, but the latest trading patterns should provide some reassurance that the massive first-half selloff that pushed stocks into a bear market may be over.

The reasons for the rebound are clear. Gasoline prices have fallen every day since peaking at $5.016 a gallon on June 13, dropping as low as $3.99 amid a broad-based decline in commodity prices and easing substantial pressure on consumers. The companies reported strong second quarter results. The labor market remains exceptionally tight, with 528,000 jobs added in July, more than double the median estimate from a Bloomberg survey. There is even optimism that perhaps inflation has peaked and will start to ease after the government said this week that its consumer price index was unchanged in July from the previous month.

All of this strengthens the case for a so-called soft landing for the economy, in which the Fed is able to continue raising interest rates, albeit more slowly, to bring inflation under control without causing a deep, long and unpleasant recession. “Such moderation in Fed messaging and actions would be positive” for stocks, wrote David Kelly, chief global strategist at JPMorgan Asset Management Inc., in a research note earlier this week.

Admittedly, this is just one metric, but the rise in the Smart Money Index was corroborated by another key metric. State Street Global Markets, which has about $38 trillion in assets under custody or administration, said its North America Investor Confidence Index rose in July the highest since February, bringing it back in bullish territory. The reason this metric is worth considering is that it is derived from actual trades rather than survey responses.

All of that isn’t to say there aren’t a lot of headwinds ahead for equities. On the one hand, the Fed is far from having finished raising its rates. Bloomberg News’ Matthew Boesler reports that Minneapolis Fed Chairman Neel Kashkari, who before the pandemic was the central bank’s most dovish policymaker, said Wednesday he wanted to see the benchmark interest rate from the Fed to 3.9% by the end of this year and 4.4% by the end of 2023. It is now in a range of 2.25% to 2.50%.

The point about higher rates is that they could translate into lower valuations for equities. Specifically, a simple discounted cash flow analysis shows that higher interest rates make future earnings less valuable in the present, making it difficult to justify today’s high multiples for stocks without strong earnings growth. The problem, however, is that valuations are not cheap after the recent rebound and earnings, while still forecast to rise, cannot be considered strong. At 18.6 times this year’s expected earnings, the S&P 500 is trading at levels more in line with a robust economy rather than one struggling to avoid recession. And at around $227, the earnings component of the S&P 500 for this year is only expected to be higher than in 2021 by around 8%.

When it comes to the stock market, there is no secret (legal) sauce that can definitively determine the direction of stocks. In the end, everyone just wants to know what the best and brightest are doing with their money so they can emulate those strategies. Right now, smart money is saying buy. More other writers at Bloomberg Opinion:

• Curb Your Enthusiasm for Good Inflation News: John Authers

• Fed damage to housing market may have lasted for years: Allison Schrager

• Meme-Stock War is Hedge Fund Versus Hedge Fund: Jared Dillian

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Robert Burgess is the editor of Bloomberg Opinion. Previously, he was Global Editor of Financial Markets for Bloomberg News.

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