U.S. stocks closed higher on Friday, 27^th January 2023, after the personal consumption expenditures (PCE) price index climbed at a slower pace of 5% year over year.  

Improving short- and long-term inflation expectations improved with the University of Michigan’s consumer sentiment climbing to 64.9, the highest in 9 months. 

Consumers expect inflation to rise 2.9% over the next five to 10 years, down slightly from preliminary readings.  

Investors bought stocks on the expectation that the Fed would hold off after an expected 25 basis point hike next week and begin to cut rates later this year. 

Once again, it was the tech that led the way, surging 1% at the end of the day. 

Here are the closing levels on Friday, 27^th January 2023:

	Last	Change	%Change
Dow Jones	33,978.08.	+28.67.	+0.08%
S&P 500	4,070.56.	+10.13.	+0.25%
Nasdaq Comp	11,621.71.	+109.30.	+0.95%
US 10Y	3.50%
VIX	18.51	-0.22	-1.17%

So, now that we have had a decent rally so far for the year. S&P is up over 5%, and Nasdaq is up over 10%. This could be part of the big rally I have been talking about in the past 2 commentaries.  

The confidence of investors in how the Fed is going to react after recent data is amazing.  

There is no room for error. The market expects the Fed to do what it wants, that is, pause and then cut later this year. 

The only way for this to work is that the Fed does exactly what the market wants otherwise we could be in for a shock. 

On the other hand, even if the Fed continues its hawkish tone, the markets may not believe it and may continue to rally.  

Technicals suggest there could be more upside and with the VIX at these low levels, buying downside protection is getting less expensive, and conducive for risk-taking.  

When markets are looking too optimistic, I like to be aware of downside risks. 

Here are a couple of articles that highlight the risk. 

Jeremy Grantham from GMO, who predicted the dot-com crash, and the 2008 financial crisis said the S&P could tumble 17% this year. 

This Recession Indicator Hasn’t Been Wrong in 56 Years: This Motley Fool article talks about the Treasury yield spread that the Federal Reserve Bank of New York used to predict the probability of a recession.  

In December 2022, this recession probability tool hit 47.31%. That’s the highest reading since 1981 and a very clear indication that economic activity is expected to slow at some point in 2023. 

Hedge Fund That Got China Right Sees Risk in US Markets. The S&P 500 and high-yield corporate debt don’t account for “the tightening cycle and the chance of recession going up,” making them vulnerable to another selloff, according to Nicholas Ferres, chief investment officer for Vantage Point Asset Management in Singapore. 

Even with these warnings, and there have been many of them, investors are still willing to go long and may probably continue to do so (FOMO). It may however be prudent to buy downside protection just in case this bubble burst. 

Source: CBOE, Bloomberg, Motley Fool

This commentary is written by James Gomes
James has been in the finance industry for over 30 years and most recently worked for a large U.S. bank for more than 20 years.

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