The stock market has defied expectations by setting another record, with the S&P 500 surpassing 5,300 for the first time on Wednesday. This comes as core inflation fell to its lowest level since April 2021 at 3.6%, although it remains high compared to pre-pandemic levels. Interest rates are also at their highest level since 2001, but the market is optimistic that both inflation and rates will eventually come down.
Despite the conventional wisdom that high inflation and elevated interest rates would cause stock market pain, the massive stock gains seen over the last two years continue to challenge this belief. Inflation is significantly worse than it was prior to the pandemic, and rates are much higher than they were in the years leading up to 2020. The Federal Reserve is expected to make two rate cuts by 2024, but even then rates would still be relatively high.
Investors are willing to pay more to get in on the action, with the S&P’s price-to-earnings and price-to-sales ratios at their highest levels since the turn of the millennium. Profit growth has yet to catch up with valuation expansions, with trailing 12-month S&P earnings lower than they were two years ago. Much of the optimism in the market is driven by artificial intelligence-related companies like Nvidia, which are expected to see significant earnings growth in the coming years.
Higher rates and inflation typically weigh on stocks, but the strong labor market has helped buoy sentiment despite these challenges. The S&P’s price-to-earnings valuation is significantly higher than it was in early 2020 when rates were lower. However, Vanguard economist Roger Aliaga-Diaz remains skeptical, stating that there is still a long way to go in the fight against inflation.
Overall, the stock market continues to rally despite concerns about inflation and interest rates. Investors are optimistic that both factors will eventually come down, leading to continued growth in stock prices. The market is pricing in significant longer-term earnings upside, particularly in sectors related to artificial intelligence. While critics remain cautious, the bullish sentiment is expected to persist as long as the labor market and other economic indicators remain strong.
