This stock market rally is not what it seems

However, perhaps the stock price has become too high.

So far, May has been a great month for the S&P 500, up 3.7%. Compare this to a disastrous April, when the index fell 4.2%.

Why did the market move this way? The prevailing narrative appears to be once again, as it has been since 2008, “bad news is good news.” This means that a weak economy is better for stocks, as central banks respond by lowering interest rates.

This week’s gains appear to have been fueled by some weak U.S. jobs data that reignited hopes of a summer rate cut. Futures markets are currently pricing in a 13% chance that the Fed will maintain policy by the end of the year, compared with 27% at the end of April, according to CME Group.

But the idea that investors are betting eagerly on an economic downturn doesn’t hold up to scrutiny.

First of all, it’s not weak at all. The U.S. labor market remains very strong, and the employment rate for prime-age workers actually rose slightly in April. In the euro zone this week, retail sales rose in March for the first time since September 2022, with a survey of purchasing managers showing the fastest economic expansion in almost a year. As of Friday, the UK is officially out of recession and is growing at its fastest pace in two years. In China, last quarter’s results were better than expected.

All this indicates that the global economy is in a “Goldilocks” stage, even as inflation remains stagnant above 2%. The experience of the past two years shows that high borrowing costs do not necessarily hurt economic growth.

And contrary to the “bad news is good news” explanation for recent stock market gains, investors are betting on companies that will benefit disproportionately from a strong economy.

To be sure, a more dovish Fed has pushed down Treasury yields and boosted utility stocks, which behave more like bonds because they are stable income payers.

But consider the “consumer discretionary” sector, which includes apparel retailers, restaurants, and automakers. Stock prices for these companies did poorly in April, when there were concerns about the economy overheating, but they have fared much better in response to weak employment data. The economy recovered by the end of the week, despite some declines, but expectations that consumers would scale back spending balanced the balance in favor of less cyclical staples, such as food brands and essential household items. should be leaning further.

A more notable example is that the KBW Bank Index outperformed the S&P 500 this month, even though banks are losers from slower growth and lower interest rates.

So how can we explain the decline in April and the rebound in early May? One undervalued factor may be valuation.

At the end of March, the S&P 500 index was doing very well, starting to trade above a high 21 times forward earnings. Some sectors, such as consumer goods, have been particularly weak. In April, the sector with the highest earnings multiple in history faced its worst decline. This is a clear sign that valuations were at the center of the decline.

By early May, the S&P 500 index was back at 20 times P/E, giving stocks room to rise again.

Further reinforcing the impression of a tug-of-war between stock prices and valuations, companies that beat Wall Street earnings expectations are being rewarded less than usual by investors, and those who miss out on The punishment is said to be above average.

This is not to say that the macroeconomic context was completely unimportant. The rise in the consumer price index raised in investors’ minds the possibility, however remote, of a second inflation spike similar to the one seen in the 1970s. This concern is likely allayed by recent weak employment data. The April CPI statistics, due to be released next week, will be another test.

Still, if the stock market hits a wall in the coming months, it seems more likely to be due to its own fault than economic problems.

Email Jon Sindreu at jon.sindreu@wsj.com.