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Wall St. Pessimists Are Getting Used to Being Wrong

Beaten as they might be by the stock market’s rally, worriers on Wall Street still question how long it can last. Their numbers are shrinking, though.

After starting the year with dour warnings about the economy, many investors and analysts have changed their minds. This newfound bullishness is grounded in signs that inflation is slowing and the economy is still standing strong, as well as a belief that corporate profits are set to grow now that interest rates have reached their peak, or are at least very close to it.

The past week gave them little reason to revert to more gloomy opinions.

Marquee earnings from some large tech companies, like Meta and Alphabet, helped drive stock prices higher. Consumer-facing companies like Coca-Cola and Unilever that are dependent on households continuing to spend also posted bumper financial results. Even the Federal Reserve chair, Jerome H. Powell, said on Wednesday that the central bank’s own researchers no longer expected a recession this year.

With that upbeat backdrop, the S&P 500 this month has extended a rally that has lifted the index almost 20 percent since the start of the year. The benchmark sits roughly 5 percent away from the record it reached in January 2022.

In other words, it’s been a difficult time to be bearish.

“We were wrong,” Mike Wilson of Morgan Stanley, one of the most pessimistic analysts on Wall Street at the start of the year, wrote in a note to clients this week.

But that doesn’t mean Mr. Wilson thinks the future will be as rosy as many investors do. He is still predicting that the S&P 500 will end the year more than 15 percent below where it is today, and he is not alone.

“I think the market is under the view that the economy is now out of the woods because the Fed is done or almost done raising interest rates,” said Eric Johnston, the head of equity derivatives at Cantor Fitzgerald. “Our view is that the risks to the economy over the coming quarters remain high.”

Central to the bearish view is the Fed’s swift and drastic increase of interest rates over the last 16 months, to a 22-year high. After another increase this week, the Fed’s policy rate is in the range of 5.25 percent to 5.5 percent, up from zero at the start of last year.

Rate increases work with a lag, meaning the economy has yet to feel the full effect of the Fed’s actions. That late effect could become a problem for companies bloated by cheap debt built up since the 2008 financial crisis. As higher borrowing costs make their way through this mountain of bonds and loans, they will increase costs for the companies involved, many of which are already struggling.

The Fed’s forecasts from June point to interest rates easing to 4.6 percent by the end of 2024, but investors are betting they will drop even lower over the same period, to 4.2 percent. The Fed’s forecasts have been wrong before, but so have the market’s.

It’s also possible that interest rates will remain higher than either expect, because inflation, while slowing, remains far from the Fed’s goal of 2 percent. Mr. Powell reiterated this week that the central bank was committed to that target, achieved by slowing the economy through higher rates.

Higher stock prices have made the Fed’s job harder, enriching investors and leaving companies and consumers with access to more money, fueling spending. That undercuts efforts to ease inflation.

These financial conditions are likely to need to change, either naturally as student loan payments restart in the fall and savings dwindle, forcing households to tighten their purse strings, or more forcefully, with the Fed raising rates even higher. Either would be bad for companies and stock prices.

Mr. Powell appeared to suggest as much this week, noting that financial conditions had become detached from the Fed’s policy but that eventually the two would most likely come back together.

“Ultimately, over time we get where we need to go,” Mr. Powell said. That could spell trouble for the stock market, some analysts said.

Brad Bernstein, a financial adviser at UBS Wealth Management, said he thought the market, at this point, was largely ignoring the Fed’s forecasts. The Fed’s “ability to predict six to 12 months from now is as good or bad as my kids predicting what the Fed will do in six to 12 months,” he said.

Business executives, on the other hand, continue to show caution about the future, judging by a variety of confidence surveys tracked by investors.

“The question is, if the unemployment rate stays low and asset prices remain high, is it going to reignite inflation and will the Fed need to come back and do more?” Mr. Johnston said. “We just don’t know, but I think that is a looming risk.”

On Thursday, investors saw a glimpse of what could happen should rates rise further. Better-than-expected economic data, combined with a report Japan’s that said central bank may relax its policy of keeping its own government’s bond yields low, sparked a rapid increase in benchmark borrowing costs around the world — jolting traders across financial markets. The Bank of Japan on Friday then said it would take steps to let bond yields edge higher.

Still, this blip did little to damage the market’s ascent. On Friday, the S&P 500 rallied again — on track for its third consecutive weekly gain — after a second inflation measure for June showed price increases slowing while consumer spending continued to rise.

The stock rally has broadened from the handful of mammoth tech companies that had an outsize impact on the market earlier this year to a set of businesses including smaller companies and those more susceptible to the ups and downs of the economy.

Roughly half the companies in the S&P 500 have reported earnings for the three months through June. So far the index has reported slight earnings growth, bucking expectations of a 7 percent contraction — although many of the companies expected to post a sharp decline have not yet reported.

“The economy is doing better than expected, and earnings are doing better than expected,” Mr. Bernstein said. “Ultimately, that’s all that matters.”

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Mohammad SHiblu

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