The Stock Market Is Vulnerable to a Bigger Drop. People Are Buying Anyway.

Central banks all over the world have raised interest rates to tamp down inflation, but those increases affect the economy with a delay. The recent data are a reminder that as the increases take effect, demand for goods and services could be hit. That might mean that companies and analysts would lower their forecasts for corporate profits, putting stocks at risk of more losses.

That is particularly true given that the stock market has become increasingly expensive, reflecting optimism about earnings. The S&P 500 is selling for a bit more than 19 times the aggregate per-share profits its component companies are expected to generate over the coming year, up from about 15 times at the start of a double-digit rally from the low point reached in October.

Thursday morning, the index was at 4510.93, but if it falls far below 4500, a level where buyers have consistently appeared in recent weeks, it could drop to about 4300. That is the next level at which buyers have come in to send the index upward. Bulls will hope that level holds steady. 

Despite the market’s vulnerability, people are putting their money into equity funds. Stock funds saw a net inflow of $4.8 billion from investors last week, according to
Bank of America.
About $83 billion has flowed in for the year, while years in which the market is generally pessimistic can see net outflows.

It might seem odd that stocks have dipped to start August, given that portfolio managers usually put money flowing into their funds to work fairly quickly, but selling from short-term traders often overwhelms buying from those managers. The point is that people still want to buy stocks. 

Investors believe there is a solid chance that the market can overcome just about anything at this point. If central banks stop raising rates soon, economies will stabilize, allowing earnings to grow next year and then keep growing, especially because the advent of artificial intelligence is expected to be a growth bonanza for Big Tech.

The U.S.’s rate of inflation has been more than cut in half form its peak, and if it remains under control, yields on short-term debt might dip as investors anticipate easier monetary policy. That would increase the current discounted value of future profits, potentially making investors willing to pay more for stocks.

Expect cash to keep flowing into stocks as long as there is reason to believe that earnings can grow and rates will remain under control. That would mean stocks will keep rising, even if the path is bumpy.

Write to Jacob Sonenshine at [email protected]