TheStreet.com:
The Fed meeting in Jackson Hole, Wyoming will have a big impact on what happens next to the stock market.
Wall Street analyst Tom Lee raised lots of eyebrows when he predicted last year that stocks would rally sharply higher in 2023.
The S&P 500 was only in the early innings of finding its footing, and recessionary worries dominated media headlines. He similarly had doubters when he said August would be a rough month for stocks, given soaring optimism had lifted stocks to a new year-to-date high in July.
Yet, that’s precisely what’s happened. The S&P 500 put in one of its best-performing first halves since 1980 through June, peaked in mid-July, and retreated 5% this month through August 18.
Given his record, investors may want to pay attention to what Lee thinks could happen to stocks when the Federal Reserve hosts its annual meeting in Jackson Hole on August 25.
Stocks struggle in the wake of surging bond yields
The 10-year Treasury bond yield is often used as the risk-free rate in equity valuation models, so rising or falling yields greatly impact stock market performance. Future earnings become more valuable when rates are falling instead of rising.
A decline in 10-year yields supported stocks earlier this year. However, surging yields since July is causing investors to second-guess how much stocks are worth, especially richly valued technology stocks that have led this year’s stock market rally. As a result, stocks have experienced a widespread pullback.
The sell-off has been painful, but it isn’t unexpected. Last month, Fundstrat’s Tom Lee reminded investors that a summertime swoon is common in August because many investors go on vacation. Rising rates haven’t helped this year, but Lee thinks yields could soon peak.
“We think probabilities favor equities bottoming at or before Fed Chair Powell’s speech at Jackson Hole this coming Friday (8/25) at 10:05 am,” said Lee on Real Money Pro.
Members use the Federal Reserve’s annual Jackson Hole gathering to discuss policy and often telegraph what will happen to rates in the future. This year, the tone could be decidedly different than last year’s hawkish, inflation-fighting rhetoric.
Inflation is above the Fed’s 2% target, but CPI inflation increased just 3.2% year-over-year in July. It was above 9% in June 2022.
Progress made in lowering inflation may give the Fed wiggle room to talk more dovish. Lee thinks that’s likely in the wake of surging yields.
The last time yields spiked sharply this year, it caused three of the largest bank failures in U.S. history, prompting the Fed and Treasury Department to scramble for solutions. It’s unlikely to want a repeat, says Lee.
Higher yields devalue lower-rate Treasury bonds held by banks in held-to-maturity portfolios. It also increases the likelihood that depositors shift to bonds from low-yield savings accounts, increasing the likelihood that banks have to sell bonds at losses to cover withdrawals.
Fitch recently highlighted this risk when it warned on August 15 that bank downgrades could happen — rival Moody’s similarly cut ratings on a slate of banks earlier this month.
The prospect the Fed’s rhetoric shifts friendlier to investors to avoid something breaking in the banking system again could mean yields are about to peak, helping stocks.
“Bottom line: We see this selloff as likely ending at or before the Fed Chair’s speech at Jackson Hole on 8/25,” concludes Lee.
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