This stock-market rally isn’t what it seems

But it may be that stocks just got too expensive.

So far, May has been a great month for the S&P 500, which is up 3.7%. Compare this to the index’s dismal April, when it shed 4.2% in value.

Why did the market whipsaw like this? The popular narrative seems to be—as in the post-2008 period—that “bad news is good news” again. That is, that a soft economy is better for stocks because central banks respond by lowering interest rates.

This week’s rally appeared to be boosted by a couple of weak U.S. job reports, which reignited hopes of a rate cut in the summer. Futures markets now price in a 13% chance that the Fed will stand pat by the end of the year, compared with 27% at the end of April, according to CME Group.

But the idea that investors are enthusiastically betting on a weak economy doesn’t stand up to closer scrutiny.

For one, it isn’t weak at all. The U.S. labor market is still extremely robust, and prime-age employment rates actually edged up in April. In the eurozone, retail-sales figures for March showed their first increase since September 2022 this week, and purchasing managers’ surveys pointed to the fastest economic expansion in nearly a year. As of Friday, the U.K. was officially out of its recession and growing at the fastest pace in two years. In China, the last quarter turned out better than expected.

This all points to a “Goldilocks” phase for the global economy, even with inflation stuck above 2%. The experience of the past couple of years shows that high borrowing costs don’t always hit economic growth.

Also running counter to the “bad news is good news” explanation for the recent rally, investors have been betting on companies that benefit disproportionately from a strong economy.

True, a more dovish Fed has pushed down yields on Treasurys and lifted the shares of utilities, which behave a bit like bonds because they are steady income payers.

But take the “consumer discretionary” sector, which includes apparel retailers, restaurants and carmakers. Shares in such firms did badly in April, when the concern was allegedly an overheating economy, and have fared much better following the weak employment numbers. Despite losing some luster by the end of the week, anticipation of consumers rolling back spending should have still tilted the balance even more clearly in favor of less-cyclical staples, such as food brands and must-buy household products.

A starker example is the KBW Bank index outperforming the S&P 500 this month, even though banks would be losers from slower growth and lower rates.

What, then, is the explanation for the April selloff and the early May rebound? One underappreciated factor may be valuations.

At the end of March, the S&P 500 had done so well that it started to trade above the high level of 21 times expected earnings. Some sectors, such as consumer discretionary, have been looking particularly frothy. In April, the sectors with the highest earnings multiples relative to history faced the worst declines—a telltale sign that valuation was at the heart of the selloff.

By the start of May, the S&P 500 was back to trading at 20 times earnings, and stocks had some room to rise again.

Further supporting the impression of a tug of war between share prices and valuations, companies have been rewarded less than usual by investors for beating Wall Street’s profit expectations, and punished more than average when they miss them, according to FactSet.

This isn’t to say that the macroeconomic backdrop didn’t matter at all. Bumpy consumer-price index readings had raised the possibility in investors’ minds, however remote, of a 1970s-style second spike in inflation. This worry was likely soothed by the recent soft payroll numbers. April CPI data, due to be released next week, will be another test.

Still, if the stock market hits a wall in the months ahead, it seems more likely to be of its own making than the economy’s.

Write to Jon Sindreu at jon.sindreu@wsj.com