A Disturbance in the Force

Last week began with stocks ripping higher at warp speed as crude oil prices declined for a fourth consecutive session and shares of hyperscalers, semiconductor and software companies posted galactic gains. Front-month West Texas Intermediate (WTI) futures, which traded above $105 per barrel as recently as the previous Tuesday, fell 4.5% on Monday to below $96. Shares of Meta Platforms (META) rose 11% in Monday’s session and Advanced Micro Devices (AMD) gained nearly 10%. For the day, the S&P 500 Index (SPX) added 1.49% and the NASDAQ Composite Index (COMP) tacked on 2.26%. Great, kid. Don’t get cocky.

Unfortunately, that early-week rally brought what would be the indices’ highs of the week. For the week, SPX gained 1.21% and COMP rose 2.06%. But that minor giveback, from Monday’s close to Friday’s, masks some significant disturbances in several pockets of the market: energy prices, interest rates and market breadth.

Declining crude oil prices were a positive force for stocks last week. WTI crude fell from about $98.40 Monday morning to $92.44 at Friday’s close. Amid the high-profile political doings last week were occasional promises that the Strait of Hormuz could reopen soon. There’s a tendency for owners of crude oil futures to rush for the exits on even a hint of a chance that the strait will reopen. No one wants to be long crude oil if/when tankers can again freely pass through the strait. I’d just as soon kiss a Wookiee.

The market’s dark side last week was the massive spike in interest rates. The 30-year yield rose to its highest level since 2004 while the 10-year yield hit its highest level in 19 years. In my most recent commentary one-month ago, “Deficit Attention Disorder”, I focused on the forces behind the uptrend in interest rates. My theory was, “Even if rates quietly tiptoe a bit higher, it would likely have little impact on the stock market. But take note if long-term rates and interest-rate volatility spike higher.” Both did indeed spike higher last week, but while the market did initially flinch when the yield on 10-year Treasury notes shot from 4.94% to 5.14% Wednesday morning (SPX lost about 0.75% that day), rallying tech stocks and declining oil prices diminished interest-rate concerns.

There were signs of weakness in the force even before interest rates shot higher. Call it “Diagnosis: Halitosis.” The overall stock market has been suffering from bad breadth. Only four of the 11 S&P industry sectors had gains last week. Fortunately, the gains were in sectors that account for about 67% of SPX’s market cap (technology, +3.52%; communication services, +1.94%; healthcare, +1.37% and industrials, +0.40%). Only two, technology and communication services have net gains over the last five weeks. For the past several weeks, the New York Stock Exchange (NYSE) recorded more new 52-week lows than new highs. And the cumulative advance/decline lines for both SPX and COMP were making new multi-month lows even as the indices flirted with new highs. Through last week, which saw SPX and COMP finish higher, the NYSE recorded 575 new lows and just 70 new highs. Last week 1,906 NYSE stocks had losses for the week, with just 919 posting gains.

Another symptom of that disease is in the performance of non-large-cap stocks, or lack thereof. Last week, the equal-weight S&P index (RSP) was down 0.20%, and the Russell 2000 Index of small-cap stocks (RUT) fell 0.75%. Over the last five weeks, while SPX had a net gain of 0.90% and COMP was up 3.39%, RSP lost 4.57% and RUT fell 6.00%. A Chewbacca-sized chunk of that negative bias can be ascribed to groups of stocks with a higher sensitivity to interest rates. All 30 of the S&P stocks in the real estate sector had losses over the past month, ranging from -2.52% for Host Hotels & Resorts to an 18.09% loss for Weyerhaeuser Co. Coincidentally, 30 of the 31 S&P stocks in the utilities sector also have one-month losses. The AES Corp. is the only winner for the group over that time, up 0.95%. Two of the big utility companies were on the losing end. Edison International is down nearly 30% in the past month, while PG&E Corp. lost nearly 33%.

The market averages, especially the cap-weighted indices, are holding up nicely even in the face of elevated crude oil prices, record-high interest rates and deteriorating market breadth. If rates and/or energy prices begin to trend lower, then order can be restored in the force. Third-quarter earnings season is right around the corner. A little more knowledge will light our way. If earnings and forward guidance come in ahead of expectations, as they often do, the averages could easily see new highs before the end of the year.

In the words of Han Solo: “Traveling through hyperspace ain’t like dusting crops, farm boy.” There’s a lot riding on the continuation of the artificial intelligence (AI)-led growth and capital spending cycle. It was one of the key contributors to the spectacular growth in corporate earnings and the expectation of that growth continuing. And as the mass of market capitalization within the AI orbit expands, even experts in the field have widely divergent views on what companies will be the AI winners and losers in the years ahead.

Over the last couple years, the gravitational pull of all things AI has drawn companies in a variety of industries into its orbit. Beyond the sphere of the chip stocks, the computer hardware stocks and the hyperscalers, companies in industries as diverse as refrigeration, power generation and optical fiber cables have thrived in the AI atmosphere. Private equity and private credit funds also now have an increased dependence on the future of AI. The appearance of diversification sought by investing in a variety of the industries and funds above could be an illusion if those investments are now highly correlated.

The economic reports with the best chances of trumping the employment reports this week will be the inflation data in the personal consumption expenditures (PCE) price index reports on Wednesday.

Links to previously published commentaries can be found at benjaminfedwards.com/Library/Market Commentary

5965802 EXP. 09/30/2029