Something strange happened to the stock bull’s best arguments as the market slumped to its worst week since June: They turned out to be right.

Corporate America is enjoying the fattest profit margins in seven decades. Consumers, still flush with cash, remain optimistic. Together, it might’ve been too much for Jerome Powell -- a man who likely opposes market confidence as he fights inflation. His blunt warning Friday that the economy will be a victim in the battle sent stocks into a tailspin.

The S&P 500 plunged more than 3 per cent after the Federal Reserve chair said additional jumbo-sized hikes may be warranted and rates will remain elevated until inflation eases. Bringing down prices “is likely to require a sustained period of below-trend growth” and an increase in unemployment, Powell said at the Kansas City Fed’s annual policy forum in Jackson Hole, Wyoming.

The comments, potentially by design, hobbled bulls whose swagger itself had become a concern for policy makers intent on taming a generational surge in prices. Stocks had surged since June on speculation the Fed would begin cutting rates next year. Those bets faded as investors retrenched for an economic slowdown that might be more stressful than previously anticipated. Treasury yields were little changed, likely capped by investors seeking refuge in government bonds.  

“The market was inappropriately optimistic that the Fed was going to be able to be more dovish today and over the course of the next six to 12 months,” said Phil Orlando, chief equity market strategist at Federated Hermes. “Powell dissuaded the market from believing that, and we think stocks should go lower, materially lower.”

The S&P 500 dropped 4 per cent in the five days for its worst week since the bear market reached its nadir. Tech shares lost 5.6 per cent in the period. Virtually all of the damage came Friday, when a listless summer week turned torrid after an eight-minute policy talk that saw Powell take direct aim at market optimism.

The stock gains have been, by Powell’s own admission, a problem for policy makers, who are monitoring whether measures of stress across assets -- known as financial conditions -- are “appropriately tight” for bringing down inflation. Stocks had added as much as US$7 trillion in values from June lows and 10-year Treasury yields had slipped from multiyear highs as investors grew more confident any recession would be short and mild.

“It would not be too much of a stretch to call this an ‘anti-pivot’ speech,” Evercore ISI analysts Krishna Guha and Peter Williams wrote in a note. “Pivot optimism seems to have lingered longest in equities amid rising hopes for a risk-friendly reaction function when trade-offs emerge –- setting stocks up for a larger move lower on the day.”

While easy to miss amid the flurry of speculation ahead of Powell’s turn in Wyoming, those market optimists had gotten considerable affirmation for views that had previously been ridiculed -- that earnings don’t necessarily get crushed by inflation, and that consumer sentiment isn’t on a one-way trip to the cellar.  

In fact, a measure of US profit margins reached its widest since 1950, suggesting that the prices charged by businesses are outpacing their increased costs for production and labor, government data showed this week. Meanwhile, the University of Michigan’s final sentiment index for August climbed more than expected as year-ahead inflation expectations eased. 

For those nursing wounds Friday, it may be minor recompense, but they could be trends bulls monitor closely once the immediate implications from Powell’s speech fade. After all, from stock pickers to fast-money traders, almost everyone has hunkered down by reducing stock positions to below longer-term norms. 

Mutual funds have raised their cash holdings at the fastest rate since the global financial crisis, while equity exposure among hedge funds hovers near a two-year low, data compiled by Goldman Sachs Group Inc. show.  

“Liquidity is not great and trading desks are not fully staffed, so it’s tough to read too much into the immediate price action,” said Zachary Hill, head of portfolio management at Horizon Investment. “When desks are fully staffed after Labor Day, the market setup could look a good bit different than it does today.”

But Powell made it clear that corporate profits and happy consumers are not his agency’s priority, and if trouble redounds to those areas then that’s a price he’s apparently willing to accept -- a role reversal for a central bank that for years was the market’s biggest ally.

“Powell is telling us that until we see substantial confirmation of slowing price increases, the Fed will keep its foot on the brakes,” said Kara Murphy, chief investment officer at Kestra Holdings. “With the Fed continuing to hike aggressively, earnings are likely to see further downside in the back half of the year, making the market look even more expensive, all else equal.”