The Bulls Still Own This Market. But Cracks Are Starting to Show.

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If it looks like a bull market and acts like a bull market, it’s probably a bull market—unless it isn’t, of course. Unfortunately, there’s still plenty that could go wrong.

Of late, there’s been more to be optimistic about. After its worst first half of a year in decades, the

S&P 500 index
has climbed 15% from its mid-June low, including a 1.2% slide this past week. The

Nasdaq Composite
has rallied 20% in the past two months, putting it in a new bull market—despite a 2.6% decline for the week. The

Dow Jones Industrial Average
is up 14% from its June low after a 0.2% dip for the week.

Riskier and more speculative pockets of the market have led the rally, which has coincided with a decline in bond yields. The

Russell 2000
has gained 22% in the past eight weeks, while the technology and consumer-discretionary sectors have led the S&P 500. The

SPDR S&P Biotech
exchange-traded fund (ticker: XBI) is up 40% since mid-June.

The extreme pessimism of the first half of 2022 seems a distant memory. War in Europe, runaway inflation, a coming collapse in corporate profits, a behind-the-curve Federal Reserve forced to push the economy into recession—you don’t hear about those nearly as much these days.

A string of solid employment and inflation data, better-than-feared second-quarter results, and a pullback in commodity prices are behind the shift. The positive catalysts have boosted investor sentiment: The Investors Intelligence Bull/Bear Ratio soared from 0.60 eight weeks ago to 1.64 this past week. That means that investors describing themselves as bullish are now far more numerous than the bears.

There’s lots of money on the sidelines that could soon find its way into the stock market. Longtime bull Marko Kolanovic, J.P. Morgan’s chief global markets strategist, has a year-end target of 4800 for the S&P 500—which is about 13.5% above Friday’s close and would be a record high.

“Given our core view that there will be no global recession and that inflation will ease, the variable that matters the most is positioning,” he wrote on Thursday. “And positioning is still very low…it is now in the ~10th percentile.” That means that funds’ relative exposure to the stock market has only been lower in 10% of historical readings, according to Kolanovic.

Alongside corporate share buybacks, he expects to see daily inflows into equities of several billion dollars a day over the next few months.

Even the bulls concede that inflation is far from conquered, the Fed tightening cycle will continue, and economic growth is guaranteed to slow. But the pace and magnitude of each of those headwinds now don’t appear so dire. That’s a relative improvement, and it has the bulls pondering whether a soft landing for the economy can be achieved.

That’s far from a fait accompli—a lot still has to go right. On the other hand, although headline inflation was flat in July, that was all due to a decline in oil prices. The core consumer price index, which excludes food and energy components, rose 0.3% in July, well above the Fed’s target of a 2% annual rate of price increases. And those gains were due to stickier categories, such as rents, which won’t be reversing like gasoline prices. Inflation remains an issue.

The minutes from the July Fed meeting released Wednesday, plus speeches by a trio of Fed presidents this past week, uniformly signaled more hawkishness than is priced into the market. But that didn’t move things much. Traders continue to bet that the Fed will back off hiking sooner than officials have been publicly declaring. Yet a Fed focused on vanquishing inflation could still out-hawk the market if the data don’t improve further, lifting bond yields and pushing down stocks.

Despite the Fed’s stated intentions, the bond market is closer to declaring victory over inflation. The yield on the 10-year U.S. Treasury note remains under 3%, down from about 3.5% in mid-June, even after a quarter-point rally this past week. “Moreover, the one-year breakeven rate (the bond market’s embedded one-year-forward inflation expectation) has collapsed from 6.3% in March to 3.0% today,” wrote Leuthold Group Chief Investment Strategist Jim Paulsen. “Indeed, its decline suggests that the outlook for inflation could soon be back near the Fed’s 2% target.”

The thorniest scenario remains plausible: still-high inflation combined with deteriorating economic activity and rising unemployment. Then the Fed would have to weigh its inflation fight against supporting a faltering economy.

Management teams tended to offer ominous forecasts for the remainder of the year, even if second-quarter results were generally strong. Slowing profit growth in a suddenly not-particularly-cheap market alongside rising interest rates is a tough combination. The S&P 500’s forward price/earnings ratio has rebounded to almost 19 times, from about 15 times in June.

Overseas, the Chinese economy is shakily emerging from Covid-19 lockdowns while contending with a property-sector bust. Europe is in an energy crisis.

Technical analysts see a make-or-break moment, as well. The S&P 500 touched its 200-day moving average of around 4321 points on Tuesday, then hovered just below that barrier for the rest of the week.

“If the S&P 500 fails to rise meaningfully above its 200-dma, the bears undoubtedly will conclude that the next stop will be a retest of the devilish low, possibly on the way to a new low before the bear market finally ends,” wrote Yardeni Research President Ed Yardeni on Tuesday. “They have the calendar on their side because September tends to be the worst month for the stock market. Since 1928, the S&P 500 has dropped 1.0% on average during the month.”

Overall, there’s plenty for both bulls and bears to point to bolster their case. But after a rapid rally fueled by good news and improving data, the near-term risk/reward appears to favor the bears.

Write to Nicholas Jasinski at nicholas.jasinski@barrons.com