By Lewis Krauskopf
(Reuters) -A searing late-year rally has brought the S&P 500 to a fresh 2023 closing high, as investors bet the Federal Reserve is done raising interest rates and the U.S. economy will remain resilient in the face of tighter monetary policy.
The benchmark index closed at 4,594.63, nearly 6 points above its previous closing high for 2023 set in late July. The index gained 0.6% on Friday after bullish investors grew more confident the rate cycle had peaked following comments from Fed Chair Jerome Powell.
Signs that inflation is cooling after reaching a four-decade high last year have made investors more confident that the Fed will start cutting rates sooner than expected.
At the same time, the Fed’s aggressive rate increases so far appear to have done little damage to the U.S. economy, despite fears that tighter monetary policy would hurt growth. The S&P 500 is up over 19% year-to-date after posting its biggest monthly rise in over a year in November. The index stood about 4% below its all-time closing high from January 2022.
Stocks have faced down several crises this year, starting with the implosion of Silicon Valley Bank in March that sparked worries over the health of the broader banking system.
A legislative showdown over raising the U.S. debt ceiling became a key concern for investors months later, with equities gaining support once a deal was reached.
The S&P 500 reached its previous 2023 closing high on July 31, also spurred in part by excitement over developments in artificial intelligence technology.
A steady rise in Treasury yields - which dulled the allure of stocks compared to bonds and other investments - began eroding those gains, resulting in a sell-off that eventually erased more than half of the index’s year-to-date advance.
However, many investors came away from the Fed’s Nov. 1 meeting more confident that the central bank was close to wrapping up its rate increases. Data on Nov. 14 showed that consumer prices were unchanged on a monthly basis for October, the first such reading in more than a year, sparking a sizable stock rally.
Federal funds futures, a widely used security for hedging short-term interest rate risk, imply a Fed funds rate of 4.54% by the end of July, versus 5.12% expected three months ago for that period, according to LSEG data.
Cooling inflation has been accompanied by little of the economic damage that many expected to come with the Fed’s rate hikes - giving rise to hopes of a so-called Goldilocks scenario where the central bank is able to staunch the growth in consumer prices without badly hurting growth. The economy appears to have avoided a recession this year that was widely forecast at the beginning of 2023, though growth in key areas such as employment has slowed. The Citigroup Economic Surprise Index, which measures how economic data performs versus expectations, has been positive for virtually all of 2023.
Of course, some investors worry that the cumulative effects of the Fed’s 525 basis points of tightening are only starting to manifest and will eventually cool growth far more than currently expected.
A cadre of massive stocks has been the key engine of most of the S&P 500’s 2023 gains thanks to their outsized weightings in the index. The so-called "Magnificent Seven" -- Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Alphabet (NASDAQ:GOOGL), Amazon (NASDAQ:AMZN), Nvidia (NASDAQ:NVDA), Meta Platforms (NASDAQ:META) and Tesla (NASDAQ:TSLA) -- have seen stock gains of between about 47% and 220% so far this year. The companies perceived safety as investments given their size and competitive advantages has benefited the stocks, while a number of them have also been fueled by enthusiasm about the profit potential of artificial intelligence. The megacaps' outperformance has increased their combined weight to well over one-fourth of the entire S&P 500, meaning the stocks' moves have outsized influence on the benchmark index.
To be sure, the S&P 500’s rapid rise has also made it richly valued compared to its historic levels, which could be an obstacle for the rally.
The S&P 500 currently trades at roughly 19 times forward earnings estimates, compared to a historical average of 15.6 times.