- The S&P 500 has gained about 20% in 2023, and it's nearing all-time highs.
- For stocks to keep momentum, experts say economic data needs to convince the Fed not to raise rates further.
The S&P 500 has a new all-time high in sight, but for stocks to break any records anytime soon, it will largely come down to the Federal Reserve.
The benchmark index has gained about 20% in 2023, and on Tuesday it hovered near 4,575. That's within spitting distance of its record closing level of 4,796.56 reached in January 2022.
Investors are betting that the Fed's July rate hike was the final increase before the central bank starts loosening policy at the start of next year. Even with the federal funds rate at the 5.25%-5.50% range, stocks have had no issue pushing higher.
Experts say the momentum will only hold if fresh economic data is upbeat enough to keep investors happy but not hot enough to cause the Fed to further tighten monetary policy.
"It's less about what needs to go right, and more about what can't go wrong," Jamie Cox, managing partner at Harris Financial Group, told Insider. "We definitely need the Fed to stay on hold. Interest rates where they're at now won't impede S&P earnings. But if the Fed does raise, it would reverse the market."
Inflation eased further in July, with CPI hitting 3.0% on an annual basis. Price increases have decelerated since last summer's peak of 9.1% inflation, but the Fed still hasn't reached its 2% goal.
"The way we see it, the Fed is the market and the market is the Fed," Ken Mahoney, CEO of Mahoney Asset Management, told Insider, echoing Cox's view that the central bank must pause on hikes for stocks to move higher.
"When studying prior bear markets that led into new bull markets after a tightening cycle, you see the correlation of inflation coming down and markets going up," Mahoney added. "In the 80s, we saw a similar pattern with inflation being elevated, then quickly making progress coming down, and the market taking off as we are seeing now."
To be sure, more bearish strategists such as JPMorgan's Marko Kolanovic and Morgan Stanley's Mike Wilson have cautioned that the current rally won't last.
Wilson, for his part, wrote in a note to clients this week that he needs to see more business cycle indicators improve before conceding to a longer period of gains for stocks.
Fuel for earnings
Wall Street strategists from Morgan Stanley to Goldman Sachs have been pulling back their recession calls over recent months, with hopes of the vaunted soft-landing rising alongside stocks.
The good news will have to carry on into the second half of the year, according to iCapital chief investment strategist, Anastasia Amoroso, as a non-recessionary economy can generate fuel for earnings.
"As long as slow but steady economic growth persists, earnings should deliver and could even surprise to the upside," she told Insider. "And the Fed that's slowing or ending its rate hikes should support multiples. Steady multiples and fulfilled earnings expectations should be enough to justify the S&P 500 at 4,800 or above."
In particular, an economy that's humming along without showing signs of overheating— and thus allowing for easing of monetary policy — could be the perfect setup for a rally in financials, a sector that slumped earlier this year after the collapse of Silicon Valley Bank. To Harris Financials' Cox, because bank stocks make up a sizable portion of the S&P 500, retracing earlier losses would be enough to pull the index higher.
"Rising interest rates had a deleterious effect on bank earnings, because of the negative effect of rates on their Treasury holdings," Cox said. "Those bonds devalued when interest rates rose, and it led to major bank failures. If those conditions no longer persists, then investors will come back and bid those stocks up to levels from before the bank crisis."