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Why did the S&P 500 rally last month?

Wall Street has had a lousy year after entering a bear market in June.

The S&P 500, in particular, faced a difficult first half of the year in light of rising inflation and rising interest rates.

But last month, the blue chip index made a comeback, rising 9.1 percent in July. The Dow gained 6.7 percent while the Nasdaq rose 12.4 percent. By comparison, the FTSE 100 rose 3.5 percent over the same period.

The S&P recovery came despite the announcement of a second consecutive quarter of economic contraction in the US economy. Does this mean the worst is over for US equities this year or is it a false dawn?

Wall Street is still battling the effects of the war in Ukraine and rising inflation

Wall Street is still battling the effects of the war in Ukraine and rising inflation

What drives the market?

The Federal Reserve made its fourth rate hike last week as it struggles to contain rising prices. The central bank said it would raise interest rates by 0.75 percentage points to reduce price inflation, but fears of a recession are mounting.

Fed Chair Jerome Powell may not believe the US is in recession, but recent figures show the US economy has contracted for the second consecutive quarter.

It seems almost paradoxical that stocks can rise in this environment, but Ben Yearsley, director of Shore Financial Planning, suggests there is some logic.

“The rationale is that as economic growth weakens, investors are betting that central banks may be more reluctant to raise interest rates aggressively and that slower economic activity will help dampen inflationary pressures.”

The Fed’s comments that it “will be appropriate to slow the pace of increases” were particularly welcomed by bullish investors.

Jason Hollands, managing director of Bestinvest, adds that after the rate hike, “investors have been anticipating a spike where rates will end.

“In fact, the focus of the market has shifted from inflation, which brings higher borrowing costs, to factoring in a mild recession which is therefore likely to dampen the pace of further rate hikes.”

Better than expected results

A strong earnings season also helped US indices move higher. Apple and Amazon both reported better-than-expected earnings last quarter with optimistic forecasts.

Apple said parts shortages are easing and demand for iPhones continues, while Amazon said it forecasts revenue growth next quarter as a result of higher fees for its Prime subscriptions.

Hollands says: ‘While earnings growth is slowing in most regions, it is still positive. Nearly half of the companies have now filed a report.

Overall, about 74 percent of the S&P 500 companies that reported have exceeded consensus expectations. If we compare this with Europe and Japan, about 57 percent and 58 percent of companies, respectively, have exceeded estimates.’

Strong performance from leading technology stocks has also helped the struggling growth funds bounce back somewhat.

Scottish Mortgage has been somewhat of a gauge of global growth stocks, given its investments in Amazon, Tesla and privately owned startups.

Investment trust, which is down 34 percent this year, is up 18 percent since the beginning of July.

Other investors are more skeptical about bounce and technology stocks in general. Blue Whale fund manager Stephen Yiu recently announced that he had dumped his holdings in US technology stocks over concerns about the impact of inflation.

The fund, co-founded by Peter Hargreaves, sold its position in Alphabet last month after divesting its Amazon and Meta holdings, according to the Financial Times.

It now no longer owns any of the Faang companies – Facebook, Amazon, Apple, Netflix and Google.

Federal Reserve Chair Jerome Powell has said he doesn't think the US is in a recession

Federal Reserve Chair Jerome Powell has said he doesn't think the US is in a recession

Federal Reserve Chair Jerome Powell has said he doesn’t think the US is in a recession

Is it a good time to invest in the US again?

Investors who have relied on the US stock market for returns over the past decade were shaken up in June when the S&P 500 entered a bear market.

It is the S&P’s twelfth bear market since 1950 and the second in two years after the pandemic shut down most of the economy. In five months, the stock market had crashed by 21 percent.

So does the recent market bounce mark the end of this bear market? It’s unlikely. The previous 11 bear markets typically lasted 390 days and resulted in an average decline of 34 percent, according to AJ Bell’s analysis.

Investors should be aware of the so-called bear market rally or bear trap. This is when stocks rise rapidly, usually caused by short sellers hedging their bets and value investors looking to buy cheap stocks.

However, these rallies are usually short-lived and end as quickly as they started.

Investors will see more economic data and earnings this week, especially nonfarm payrolls that will provide greater insight into the labor market.

For British investors looking to buy US equities, Hollands warns that the current exchange rate makes it a greater risk.

The US dollar has appreciated 10 percent against sterling since the beginning of the year.

“If this trend reverses – as it appears to have been in recent days – there is a risk that underlying price gains will be dampened by currency movements.”

Yearsley added: “Last month’s performance shows the problem with trying to time markets. Who would have thought that the reaction to another 0.75 percentage point rate hike would be the best day since November 2020 for tech and Nasdaq?

‘At the same time, the old economies such as banks and oil recorded good profits and bonds recovered. With so much uncertainty, the balance of the portfolio is crucial – don’t have all your eggs in one basket.’

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