Why investors should treat the new stock market rally with caution

This is The Takeaway from today’s Morning Brief, which you can sign up to receive in your inbox every morning along with:

Stocks are flying higher, giving hope to investors looking to ride seasonal tailwinds into year-end. Since the late-October low in the major indexes, the S&P 500 is up 9% in only 13 trading days.

The latest rally is broad-based — not just the “Magnificent Seven” megacap stocks that have dominated the headlines and investor returns this year. The very antithesis of megacaps — small caps — rallied over 5% Tuesday and are up 10% over those same 13 days.

And the farther out on the “fringe” scale one travels in the universe of stocks, the better the returns seem to be.

The disruption-themed ARK Innovation ETF (ARKK) is up 26% over the period. The SPDR S&P Regional Bank ETF (KRE), which got shellacked in March, is staging an impressive 16% rebound.

The cannabis-themed Alternative Harvest ETF (MJ) is up 14%. Similarly, ETFs that track gambling (BETZ), solar energy (TAN), initial public offerings (IPO), and meme stocks (MEME) are all up about the same.

Even the poster child of cryptocurrencies, bitcoin itself (BTC-USD) is up 11% — in line with the major equity indexes.

Wall Street is paying attention — as well it should — because hedge fund performance this year is downright abysmal. The Bloomberg All Hedge Fund Index is off 7% this year while the S&P 500 is up 17%.

As Alfonso Peccatiello, founder and CEO of TheMacroCompass.com, recently wrote, this means “macro hedge funds, which must generate returns into year-end, are likely to aggressively chase market trends.”

And because Wall Street is getting caught so flat-footed, hedge funds will likely employ prodigious leverage. Many underwater money managers will also look to beaten-down laggards that have more room to catch up — in theory.

Never underestimate the potential of a short-covering or junk-off-the-bottom rally.

If that all sounds like a bad idea that could end in tears, it might just be. But hedge fund lore is replete with enough moonshot comebacks that many will give it a whirl (with other peoples’ money).

Given the strong performance earlier in the year along combined with seasonal tailwinds, the trick could work — especially if the bond market cooperates and doesn’t spook investors.

But for those investing their own money, caution is advised. ARKK is still down over 70% from its 2021 high.

It’s easy to lose your bearings in percents and remind ourselves that being down 70% means you must go up 270% to get back to where you were.

Many of ARKK’s components are still down 80% to 90%. A 2023 year-end rally won’t get them close to breakeven.

But for disciplined investors employing prudent risk management, there’s no reason not to take advantage of the momentum and opportunity — as long as expectations are aligned with reality.