Fear, Greed, And Why The Big Banks Are Still Cautious About This Rally

The rocketship rally we’ve seen this year in stocks wasn’t in any of the forecasts from big investment banks. And even now, those Wall Street giants aren’t changing their outlooks for the year. But it has sure grabbed investors’ attention: the so-called fear and greed index is now pointing toward extreme greed. So, let’s take a look at the current rally, what the big banks see coming, and what it all means for your portfolio.

So, what have the big investment banks been saying?

Well, as far as the stellar start to the year for stocks goes, they didn’t see it coming. That said, they’re still cautious in their outlook.

At the end of 2022, most of the big banks were talking about the potential for value in bonds – both corporate and government – after their sharp selloff, but few (if any) were bullish on stocks. The consensus was for a recession in the US, ongoing inflation pressures, and high interest rates – not a pretty picture for stocks.

Looking out to the end of 2023, Wall Street’s S&P 500 forecasts ranged from BNP Paribas at the low end, saying 3,400, to Deutsche Bank at the high end, saying 4,500 – with the rest mostly clustered around the 4,000 mark. That’s below the current level, mind you, and suggests they remain pretty cautious about the rest of the year.

Now, one of the biggest of the big banks – Goldman Sachs – did update its S&P 500 forecasts last week. Its three-month forecast now sees the index at 4,000 (up from 3,600), helped by better global growth, lower inflation, and increasing expectations for a “soft landing”. But, that’s where its optimism seems to end. Goldman made no change to its year-end prediction of 4,000, arguing that the recovery is already priced into US shares. The bank says this year it prefers non-US stocks, credit, and cash which it sees as offering superior risk-adjusted returns.

Meanwhile, strategists at Bank of America, Morgan Stanley, and JPMorgan all remain cautious about the outlook for the US stock market. A six-week rally doesn’t necessarily take their year-end targets off the table, but their predictions for a selloff in the first quarter seem way off the mark right now.

What’s more, a recent Wall Street Journal survey indicated that more than 65% of forecasters still think the US will enter a recession in the next 12 months. If that majority turns out to be wrong, there could be another rally, on top of the one we’re seeing now.

What’s been driving the current rally?

Stocks fluctuate because of a wide range of factors. In the long term, fundamentals, like free cash flow, are the key drivers. However, in the short term, stocks can be more volatile, and changes in sentiment and positioning can absolutely dominate. And that’s what appears to be happening now: sentiment has reached “extreme greed”, according to CNN’s fear and greed index.

Fear and greed Index. Source: CNN.

The index comprises seven indicators, each with a score of zero to 100. And right now, four of those components – stock price strength, stock price breadth, “put” and “call” options, and safe haven demand – are pointing to extreme greed. The index was in neutral territory just a month ago. And that recent, sudden shift suggests that investors might be inclined to sell their stocks and take profits in the short term.

This year, the Nasdaq is up 14% and the S&P 500 Index is up 7.7%, and that’s pretty chunky, but under the surface, stock moves have been even more dramatic. Goldman says its non-profitable tech basket, for example, is up 33%, and its retail basket is up 50%.

Those steep moves higher have caught a lot of people off guard, with hedge funds and other market players forced to buy stocks to close out their short positions as their prices have risen. It’s what’s called a short squeeze.

So, what happens next?

Mostly, this comes down to the Federal Reserve (the Fed) and how quickly it shrinks its balance sheet.

See, the Fed’s main tool – the one most people think of – is interest rates. When the pandemic hit in March 2020, the Fed quickly stepped in to limit the economic fallout and slashed its key interest rate to almost zero. But that wasn’t going to be sufficient to protect the economy, so the Fed started aggressively buying longer-dated government bonds and mortgage-backed securities – as a way of keeping interest rates low and encouraging spending. This is known as quantitative easing (QE). All that buying ballooned the size of the Fed’s balance sheet – and it went from $4 trillion before the pandemic to about $9 trillion at the start of 2022.

Now, there are differing views as to the exact impact QE has on the economy, but there’s general agreement that QE increases the prices of other assets – like stocks and real estate. This chart shows the size of the Fed’s balance sheet (white line) and the S&P 500 index (blue line). And it does suggest a pretty strong correlation between the size of the Fed balance sheet and the level of the S&P 500.

Federal Reserve Balance Sheet and S&P 500 Index. Source: Bloomberg.

Since June, the Fed has been reversing its QE policy, basically reducing the size of its balance sheet – first by $45 billion per month, then later by $90 billion per month. This (logically) is called quantitative tightening (QT).

So right now, the Fed’s balance sheet is at $8.4 trillion and by the end of 2023, it’s expected to be around $7.5 trillion.

And if you believe that the size of the Fed balance sheet is a key determinant of asset prices, then you should take note that a Fed balance sheet size of $7.5 trillion historically equates to an S&P 500 level of around 4,118 – right about where it is now.

What's the opportunity then?

In the very short term (say, the next week or so), the fear and greed index suggests that the US market is at least slightly overbought. However, stock market moves are also likely to be driven by fresh data. So, if you see new data that hints at continued improvement in global growth or a further easing in inflation, that’s likely to give a further lift to stocks and outweigh those worries about quantitative tightening, at least for a while.

For a slightly bullish trade, consider buying the SPDR S&P 500 ETF (ticker: SPY; expense: 0.095%), or for a more bullish trade, consider buying the Invesco QQQ Trust ETF (QQQ; 0.2%). But if you’re feeling really confident about the outlook, you could consider buying the ARK Innovation ETF (ARKK; 0.75%), which tends to move up and down the most on a daily basis – it has the highest beta.

But if you think the big banks are right to be cautious, you could consider an inverse, or short, index ETF, like the ProShares Short S&P 500 ETF (SH; 0.89%), or the ProShares Short QQQ ETF (PSQ; 0.95%).