What Drives This Market Rally?

People are worried.  Society seems to have degenerated into partisan bickering and, too frequently, violence.  Democrats and Republicans seem more set on thwarting each other than serving the nation.  Inflation seems to have gotten away from the Federal Reserve (Fed).  Supply chains are failing.  And yet, despite this dispiriting picture, stocks continue to rise.  Is it that market participants are unaware of all these seeming problems, or is it that they see something else about which to be optimistic?

This is a good question –– in fact, it’s the question of the day.  And it has a three-part answer:

1. However many worries there are about inflation or political strife, the Fed, as it has for some time now, continues to flood financial markets with liquidity.  This liquidity has created a surplus of loanable funds at banks and other financial institutions, and it has put cash directly into investors’ hands through the Fed’s outright bond purchases (what the Fed refers to as quantitative easing). The low interest rates that are a part of this program have made it easy and even profitable to borrow.  All that liquidity –– that money –– must flow somewhere.  Much of it has flowed into real estate from both investors and actual homeowners.  A good part has flowed into stocks, despite all the worries, and pushed up stock prices accordingly.
2. The authorities – Fed Chairman Jerome Powell, Treasury Secretary Janet Yellen, and even President Joe Biden – have reassured all who would listen (and some who would rather not listen) that supply chain problems will lift soon and so will inflationary pressures.  Many financial professionals are skeptical but are still reluctant to sell in case the official forecast turns out to be accurate.
3. Despite all these concerns, corporate profits continue to come in strong.  The pace of recent economic growth has slowed (as most knew it would), but nonetheless reports from the last quarter show an improved profitability across most firms and industries.  Professional and retail investors naturally want to participate in that improvement, and that means buying stocks.

While this might explain the continued upward trend in stock prices, it should also reveal the market’s vulnerability.  If supply chain problems and/or inflation persist long enough to discredit the assurances offered by the authorities, the news would not only remove one of the three market supports described above but it would also raise questions about the competence of those in charge.  Either of these developments could prompt a market retreat.  Because the Fed has premised its continued provision of at least some of the liquidity flow on the assumption that inflation will soon dissipate, its policy would have to change more completely should that dissipation not arrive.  From today’s low interest rates and monetary ease, the Fed could seek to raise interest rates and increase monetary restraint, in which case the present bull market would lose another of these supports.  And if the economy slows – either from monetary restraint or other causes – the good news about corporate profits will stop, removing yet another support for stock prices.

For the long-term investor – and, as this blog has explained many times, anyone in stocks should be a long- not a short-term investor – this information should be of interest, but not necessarily require action.  Even if market prices do fall, the long-term investor would do well simply to weather the paper losses, secure in the knowledge that in time stock prices will recover their lost ground and then some.  But if the investor anticipates a near-term need for cash that is currently invested in stocks, then these market vulnerabilities might signal a good moment to withdraw those funds –– but only in amounts the investor anticipates needing.

And, to conclude with my general warning: trying to time the  market is always dangerous.