Stocks may rise into the summer. These 3 risks could derail the rally.

By Joseph Adinolfi

Weak Nvidia earnings, a slowing economy, or even the rally becoming overdone are all potential risks, market strategists say

Bad news for the economy is once again good news for the stock market. So is good news, market analysts say.

Given how U.S. stocks reacted this week to the latest flurry of mixed economic data, a summertime rally feels almost inevitable.

Stocks rose this week after the U.S. April CPI released on Wednesday by the Bureau of Labor Statistics showed the pace of inflation slowed more than economists had expected last month. Core prices increased by 3.6% year-over-year. While that's still well above the Federal Reserve's 2% target, it's also the lowest reading since April 2021.

The upshot for investors has been pretty clear: "goldilocks" is back, along with expectations that the Federal Reserve will achieve its aim of guiding the U.S. economy toward a soft landing as monetary policy helps to bring inflation down.

This is an ideal scenario for stocks, bonds, commodities, cryptocurrencies and everything else that has rallied hard this year, market analysts told MarketWatch.

"A Goldilocks scenario where growth remains healthy and inflation is cooling has historically been a favorable backdrop for risk assets," said Andrew Krei, co-chief investment officer at Crescent Grove Advisors, a boutique wealth-management firm, during an interview with MarketWatch.

Still, investors would be remiss not to consider the myriad risks that could possibly derail the rally - at least temporarily.

After all, even the most bullish strategist on Wall Street, BMO Capital Markets' Brian Belski, expects some volatility in the coming months, according to a report shared with MarketWatch on Wednesday that saw Belski raise his year-end S&P 500 index target to 5,600.

With that in mind, MarketWatch has canvassed a handful of market strategists about what they see as the biggest risks to the rally. This is what they said:

Earnings season ends with a whimper

The latest quarterly earnings reporting season has been solid so far, although stocks that missed Wall Street's expectations were swiftly punished by the market.

As of Friday afternoon in New York, 470 of the 500 companies whose shares are included in the S&P 500 had reported earnings. Of these, 78% surpassed Wall Street's typically conservative forecasts for earnings per share, more than the 10-year average, according to FactSet data.

However, there are still a few companies left to report, and one in particular has the potential to upend the market: Nvidia Corp. (NVDA)

The chipmaker has benefited enormously from the artificial-intelligence boom, perhaps more than any other company. Now, Wall Street expects its revenue for the most recent quarter will come in at $24.5 billion, which would be an increase of 240% from a year before.

If investors' response from the past few quarters is any indication, Nvidia needs to not just meet Wall Street's forecasts, but meaningfully surpass them.

And if the chip designer's results show any signs that the pace of demand for Nvidia's products is starting to slow, the broader market will likely feel the blowback, said Steve Sosnick, chief market strategist at Interactive Brokers, in written commentary.

"If they can continue their enviable, remarkable string of beating estimates, raising guidance, then beating the raised guidance next quarter, that means that the AI trade can and will proceed apace," Sosnick said about Nvidia.

"If there is even the slightest sign of weakness, however, much more than that stock alone will suffer."

Economy shifts from 'soft' to 'hard' landing

There's no question that the U.S. economy is doing fine right now. After all, the Atlanta Fed's GDPNow services is forecasting 3.4% growth during the second quarter.

But economic data for April released so far have hinted at an incipient slowdown that could snowball, potentially threatening markets, analysts said.

The evidence can be seen in a number of different data series. For starters, the unemployment rate ticked higher last month. Also, the number of Americans applying for jobless benefits has started to climb over the past few weeks. Pair this with signs that the number of job openings are shrinking, and it would appear that the labor market is finally starting to cool.

Meanwhile, U.S. retail sales stagnated in April, while economic activity in the services sector contracted for the first time since December 2022, according to the Institute for Supply Management's non-manufacturing PMI.

Taken together, these data suggest that for the first time in well over a year, the economy appears to be losing momentum, said Tom Essaye, founder of Sevens Report Research.

So far, this has been welcome news for economists and market analysts, but there's a limit to how much the economy can weaken before it starts to weigh on stocks.

"While data is still pointing towards a soft economic landing, hard landing risks did rise last month," Essaye said in written commentary shared with MarketWatch.

"That's important for investors because an economic hard landing is one of the few 'rally killing' threats out there right now."

Stocks could sink under their own weight

Sometimes, too much of a good thing is no longer a good thing.

Applied to markets, this means that, so long as inflation remains north of the Fed's 2% target, an ongoing rally in stocks and bonds risks reigniting the wealth effect and inflation with it, according to Crescent Grove's Krei.

Put another way, if the rally goes too far, it could essentially sow the seeds of its own destruction.

If falling Treasury yields coincide with a reacceleration in inflation, Chair Powell could be forced to step in once again and deliver a blow to markets like he did in August 2022 during his speech at the Kansas City Fed's Jackson Hole economic symposium.

Powell could easily accomplish this by putting another Fed interest rate hike back on the table, analysts said.

The Fed hasn't raised interest rates since July last year, and Chair Powell's decision to declare another Fed rate hike "unlikely" earlier this month helped trigger an enthusiastic reaction in markets. As a result, the Chicago Fed's gauge of financial conditions - essentially a gauge of how easy it is for borrowers to access credit - has sunk to its lowest level since January 2022.

There's already talk of how the latest pullback in Treasury yields appears to be triggering a raucous "melt up" in equities. Defensive utility stocks are trading as if they were the hottest new artificial-intelligence play, something that Michael Kantrowitz, chief investment strategist at Piper Sandler, never thought he would see. And this week, a post from a long-dormant X account triggered a short-lived replay of January 2021's "meme stock" mania.

"Perhaps both the bond and equity market need to cool off for a moment, as a melt-up that gets too hot is at risk of boiling over," Kantrowitz said in emailed commentary.

Next week, investors will hopefully gain more insight into the Fed's thinking about where interest rates are headed when minutes from the May 1 policy meeting are released. Aside from the minutes, they will also receive another update on the state of the manufacturing and services sides of the U.S. economy when IHS Markit releases their preliminary PMIs for May.

A final reading on consumer sentiment from the University of Michigan rounds out the main events on next week's economic calendar.

On Friday, the Dow Jones Industrial Average DJIA closed north of 40,000 for the first time ever, while the S&P 500 SPX finished just shy of a fresh record, closing at 5,303.27 as the major stock-market barometers clinched their longest streak of weekly gains since February.

Only the Nasdaq Composite COMP finished lower on Friday, but still managed a respectable weekly gain of 2.1%.

-Joseph Adinolfi

This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.

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05-19-24 1201ET

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