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The stock market rally isn't over yet, Deutsche Bank strategist says

While the recent stock market rally looks to be on shaky ground, Deutsche Bank says staying the course makes sense into the New Year as the Federal Reserve dials back the pace of its interest rate hikes.

"We look for rates volatility to fall as the Fed slows the speed of hiking and as policy rates are closer to eventual terminal rates," Deutsche Bank strategist Binky Chadha wrote in a note on Tuesday. "We look for equity volatility to fall with rates volatility, for systematic strategies to raise equity exposure from extremely low levels, and see the equity rally as having further to go."

Chadha's research shows that stocks have tracked interest rate volatility in the past few months, and he expects that trend to continue moving forward and benefit stocks.

"While the S&P 500 has been at its current level 4 times over the last 5 months, and rates successively higher at each point, it has tracked implied rates vol which was at similar levels each time," Chadha said. "Moreover, on the occasions when rates and rates vol did diverge, the equity market has followed rates vol rather than the level of rates."

Investors have enjoyed somewhat of a reprieve of late to the selling that has dominated markets for most of 2022, as the Fed's aggressive interest rate hiking is expected to slow.

Amid signs of an easing in inflation, lower oil prices, and a renewed drop in the U.S. dollar, stocks have rallied since those the October lows. In the past month, the Dow Jones Industrial Average (^DJI) is up 3%, the S&P 500 (^GSPC) has gained 1.6%, and the tech-heavy Nasdaq Composite (^IXIC) is mostly flat.

Those gains are under pressure as concerns mount over a contentious COVID-19 lockdown situation in China and how large manufacturers such as Apple will be impacted.

Chadha's argument is at odds with a recent Goldman Sachs note that asserted stocks are likely to take their cue from the near-term path of rates and economic growth than expectations on rates further out.

"We remain relatively defensive for the three-month horizon with further headwinds from rising real yields likely and lingering growth uncertainty," Goldman Sachs strategist Christian Mueller-Glissmann wrote.

A husky sticks its head out of the car window after a snow storm in Louisville, Kentucky, U.S. January 6, 2022. REUTERS/Amira Karaoud
A husky sticks its head out of the car window after a snow storm in Louisville, Kentucky, U.S. January 6, 2022. REUTERS/Amira Karaoud

Mueller-Glissman recommended that investors go Overweight (have more exposure to) cash and credit in the near-term. The investment bank, which is Underweight (have less exposure to) bonds and stocks, sees opportunities to "add risk" in 2023 — but the moment isn't now.

"Without depressed valuations, for markets to trough investors need to see a peak in inflation and rates, or a trough in economic activity," Mueller-Glissmann added. "The growth/inflation mix remains unfavorable – inflation is likely to normalize but global growth is slowing and central banks are still tightening, albeit at a slower pace."

Brian Sozzi is an editor-at-large and anchor at Yahoo Finance. Follow Sozzi on Twitter @BrianSozzi and on LinkedIn.

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