Markets and Economy Bull market check-in: Key signals to watch

This has been a spectacular bull market, notwithstanding the recent sell-off in the semiconductor trade.¹ Stocks pushed higher this year² despite geopolitical tensions, rising energy prices,³ and a steady stream of prognostications that the rally had been nearing its end. Against that backdrop, it was hardly surprising to hear JPMorgan CEO Jamie Dimon describe the current environment as “close to as good as it gets” in this quarter’s earnings report.⁴ For large financial institutions, the backdrop has been exceptionally favorable. Capital markets have been open, and initial public offering (IPO) activity has picked up.⁵ Trading volumes have remained healthy.⁶ Wealth management businesses have been benefiting from rising asset values. Dimon is right in my view. It has been a prime operating environment for the banking industry.

Dimon was also quick to add the caveat that it will not last forever. That portion of the quote received considerable attention and could easily be interpreted as an ominous warning. I didn’t take it that way. Saying that good times eventually come to an end is hardly a controversial statement. Bull markets don’t end simply because someone observes that they will. They end when the conditions that support them begin to deteriorate. So what conditions could cause investors to grow more concerned?

What to watch: Inflation, the Fed, and fundamentals

Historically, one answer has been rising inflation accompanied by a Federal Reserve (Fed) that’s actively tightening policy and squeezing credit growth. There was little evidence of that this week. Consumer prices declined last month⁷ as energy prices fell in June,⁸ while producer price inflation came in softer than expected.⁹ Meanwhile, Fed officials struck a relatively dovish tone. New York Fed President John Williams argued that inflation has likely peaked and should move lower over the coming quarters.¹⁰ Perhaps more importantly, Fed Chair Kevin Warsh emphasized that the massive investment being directed toward artificial intelligence (AI) should eventually generate a supply response that boosts productivity and places downward pressure on prices.¹¹ That’s likely not the language of a central bank preparing to aggressively tighten policy.

Another reason investors typically become bearish is when fundamentals begin to erode. There’s no doubt that the AI trade has been entering a more demanding phase. Expectations have risen significantly, and companies that beat estimates aren’t always being rewarded the way they were a year ago. Markets appeared to be transitioning from a period driven largely by earnings surprises to one that may depend more heavily on the durability of future earnings growth. In other words, investors are becoming less impressed by companies exceeding expectations and more focused on whether today’s growth can be sustained.

That transition, however, shouldn’t be mistaken for deterioration. Earnings growth has remained strong across a broad set of sectors.¹² In fact, one of the more encouraging developments has been the improvement in market breadth, with equal-weight indexes outperforming¹³ and leadership expanding beyond the largest technology companies. Financials, industrials, and other cyclical groups continued to contribute to market gains.¹⁴ Just as importantly, there has been little indication of the significant earnings disappointments or broad downward revisions that typically accompany the onset of a bear market.

No warning signs yet

Markets ultimately can become vulnerable when earnings expectations start moving materially lower, and monetary policy becomes restrictive at the same time. We consider that combination a more reliable warning signal than elevated valuations alone. Today, the evidence has pointed in the opposite direction. Inflation appeared to be cooling, the Fed sounded less inclined to tighten, earnings growth remained healthy, and market leadership has broadened. Investors should always keep in mind that no bull market lasts forever. But the ingredients that typically end bull markets, including significant earnings misses, falling revisions, tightening liquidity, and restrictive monetary policy, simply don’t appear to be in place today.