What to do with the stock rally?

U.S. stocks have bounced back from their lows in October, despite a slew of disappointing earnings reports from some of the biggest tech companies. The S&P 500 is up over 8% from its most recent low, as investors seem to be betting on a less hawkish Federal Reserve and a peak in global monetary tightening. But is this rally sustainable, and how should investors position themselves for the next several months?

The Fed Factor

Most of the strain and gain in the market is coming from this alone. Stocks are a long duration asset, doesn’t mean much to you besides the fact that it makes stocks sensitive to changes in interest rates. It also makes them sensitive to changes in interest rate sentiment, if investors think rates will rise… or rates will fall, the prices change. That is why we have seen this rally, a change in sentiment around interest rate policy.

The Fed is facing a difficult dilemma as it prepares for its next policy meeting in May. On one hand, it has to continue its battle against inflation, which has remained stubbornly high despite nine rate hikes since last March. On the other hand, it has to deal with the fallout from the collapse of two major banks, which has triggered a crisis of confidence and liquidity in the banking system.

The Fed has been providing emergency loans to banks and other financial institutions to ease the stress in the money markets and prevent a credit crunch. It has also coordinated with other central banks to increase the availability of U.S. dollars around the world. However, these actions may not be enough to restore stability and trust in the banking sector, which could have negative consequences for the economy and inflation.

The Fed's decision in May will depend on how the situation evolves in the coming weeks. If the banking crisis worsens or spreads to other sectors, the Fed may have to pause or slow down its rate hike cycle, or even cut rates if necessary. If the banking crisis is contained or resolved, the Fed may resume its rate hike path, or even accelerate it if inflation pressures intensify.

The Fed's tone and guidance will be crucial for the market's reaction, as investors will look for clues on how the central bank balances its dual mandate of price stability and maximum employment. The Fed's chair, Jerome Powell, will also face tough questions from lawmakers and journalists about the Fed's role and responsibility in overseeing and regulating the banking system.

Earnings Pressure

Now in the long term earnings are really the only thing that matters. Did x company earn more over the last 10 years? That makes them more valuable. Changes to the earnings outlook effects short term stock prices changes namely by changing the valuation that stocks trade for. If earnings fall, investors will still want to pay the same amount of money for each dollar of earnings, leading to a price decline. Sometimes they want to pay even less leading to changes in market valuation… which is something we have seen.

One of the biggest challenges for this stock rally is that it had to face a tough earnings season in the fourth quarter of 2022. Many companies have reported lower than expected profits, citing various headwinds such as higher interest rates, supply chain bottlenecks, labor shortages, rising costs and slowing demand.

Some of the most influential companies in the market have reported disappointing results for the fourth quarter, such as Amazon, Microsoft, Alphabet and Meta Platforms. These companies have faced challenges such as regulatory scrutiny, competition, privacy issues and slowing growth.

However, investors may not be deterred by these earnings misses, as they may focus on the positive aspects of these reports, such as strong cash flow generation, robust cloud computing growth and increased user engagement. Moreover, investors may be looking ahead to a better earnings outlook for 2023, as some of the headwinds facing these companies ease or are priced in.

What about Bonds

Now we are getting to the meat of this post. Because forever bonds have been the trash asset class. Investors have been slowly drifting portfolios towards higher stock allocations because there was no return in bonds.

With bond yields, in some cases, north of 5% that return has come back.

They also provide protection against some declines in stock prices, again in some cases.

The outlook on bonds is also looking incredibly positive. On top of the 5% yields you also benefit from an inevitable Fed pivot as declines in yields boost bond prices.

But the largest question is whether or not today is the best time to pull the trigger on bonds or not.

In the long term of course it really doesn’t matter, but for an attractive entry point I have heard adding bond allocations above a 3.75% 10 year is the move. It’s hard to say if we will hit that rate again though, it may be worth waiting a bit to see how the banking and employment/inflation situation shakes out over the coming weeks.

What I am Doing

I am simply putting money in every month. I currently am buying only stocks, but in the coming months I may switch some of my allocations towards bond positions to add some stability until the stock outlook is more favorable, that’s the beauty of high interest rates.