By Pete Biebel, Senior Vice President, Senior Investment Strategist
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For most of this year, investors have pined for lower interest rates. Early in the year, they conjured up a vision in which the U.S. Federal Reserve (Fed) would reduce its overnight lending rate numerous times in 2024. That dream scenario, they imagined, would lead to a nirvana of an economic soft-landing, lower inflation, lower interest rates, and pie-in-the-sky stock prices. By springtime, it had become clear that the early year pipe dream was a delusion; the rate of inflation was not decreasing quickly, and the expected number of coveted Fed rate cuts decreased from six or seven to just one or two.
Still, the hallucination was not for naught. Better than expected first-quarter earnings helped to keep the dream alive and a mania over the potential future benefits of artificial intelligence (AI) kept the mega-cap tech stocks and semiconductor stocks leading the market higher through the first half of the year. As of the end of June, the S&P 500 Index (SPX) was showing a gain of more than 14%. The NASDAQ Composite Index (COMP), with its even higher weighting in those big tech stocks, was up more than 18% in six months. The yearning for Fed rate cuts was still alive and still fueling bullishness in the stock market.
But something changed in July. Three weeks ago, in my article “A Wrench in the Works,” I described how the market’s smooth-running machinery seemed to have suddenly gone on the fritz. The big tech stocks were fading, and the lowly small caps were rocketing higher. One of the previously unloved sectors, regional banks, gained 20% in just three weeks. Was the sudden strength in small caps the beginning of the long-awaited widening of breadth? I wish! Outperformance by small caps is typically in the early stages of a new bull market. In fact, the extreme concentration of leadership and euphoria over AI and chip stocks are phenomena that are far more likely to occur in the late stages of a bull market.
The prevailing theory in recent weeks has been that the rush into AI and chip stocks was overdone. The latest spin was that the companies were investing huge amounts of capital that would likely not see much payback for years. Just a small shift in sentiment in such a crowded trade can have a big impact as more and more positions are unwound. Consider too that many of the most recent buyers were momentum traders, buying whatever was climbing the fastest. Such traders typically maintain stop-loss orders just below current market prices to limit their risk. Just a small pullback in one of the momentum stocks could trigger some stop-loss orders, which in turn would cause more downward pressure, triggering more stop-loss orders.
As investors reduced positions in those big winners, some – maybe much – of the proceeds flowed into stock sectors that represented better value. It was a wish come true for many of the underperforming pockets of the market. That inflow not only fueled big gains in small caps and regional banks, but also rare outperformance in defensive sectors like real estate, consumer staples and healthcare. Coming into last week, the Russell 2000 Index of small-cap stocks (RUT) had gained nearly 12% in just the previous five weeks. Over that same stretch, the real estate sector climbed by nearly 6% and had recovered to a net gain for the year. In contrast, the technology sector had declined by more than 5% over that same five-week period.
The market’s wheels had been wobbling as that rotation trade unfolded in July. Last week, the wheels fell off. The averages were essentially flat through the first half of the week. Traders were awaiting Fed Chairman Powell’s press conference following the end of the Federal Open Market Committee’s meeting on Wednesday. Stocks generally rose that afternoon as traders concluded that the chairman’s comments increased the odds of a September rate cut. The employment news on Thursday morning was the pothole that spoiled the ride. Initial jobless claims were reported at 249,000, well beyond the expected 235,000. Continuing claims came in at the highest level since November 2021 at 1.877 million.
The market hit a second pothole Friday morning when the employment report showed nonfarm payrolls increased by just 114,000, far fewer than the 185,000 expected, and the smallest increase in almost four years. The same report also showed the unemployment rate jumping to 4.3%, its highest level in almost three years. Unfortunately, the employment news wasn’t the only rough patch; other recent reports showed both durable goods orders and factory orders declining by their largest month-over-month changes since April 2020.
The net effect of that news was that it exacerbated the rush out of tech, pulled the rug out from under the rally in small-cap stocks, and triggered the largest decline in benchmark 10-year Treasury note yields in more than four years. By Friday’s close, COMP was down more than 3% for the week and is now down by a bit more than 10% from its closing high on July 10. SPX fell 2%. Both indices are now below their 50-day moving averages and back into price ranges that they had not seen in two or three months. The technology sector fell more than 5% for the week and has now lost more than 12% in just three weeks. The SOXX semiconductor stock index fell nearly 10% last week, bringing its three-week loss to more than 20%.
But RUT was okay, right? Wishful thinking. RUT tanked nearly 7% last week and has now given back about 70% of its July moon-shot rally. The S&P regional banking index fell more than 9% and has now given back more than 50% of its July rally.
What was okay were bonds and interest rate-sensitive sectors, thanks to the plunge in Treasury yields. The yield on 10-year Treasury notes, which was near 4.5% in early July, had slumped to below 4.2% by the end of the month. It ended last week at 3.8%. The aforementioned real estate sector tacked on another 3% or so. It ended last week at its highest level in nearly two years. The sector that got the biggest charge from the lower rates was utilities. That sector powered ahead more than 4% last week and now leads all other U.S. equity sectors AND all the major indices in year-to-date gains. I don’t think anyone wished for that.
The wish for lower interest rates seems to be coming true but for the wrong reason. Instead of wishing for lower interest rates to boost stock valuations, investors have suddenly shifted to worrying that the suddenly lower interest rates are signaling a greater potential for recession and weaker stock valuations. Where investors were hoping for a quarter-point cut in September, that is now practically guaranteed. The odds of a half-point cut next month have soared to greater than 70%.
The past few weeks have seen significant deterioration in the technical condition of the major averages and the most important sectors. Though the market is short-term oversold, additional downside in the coming weeks is likely. On our Research call with advisors midweek last week, I warned that if SPX broke below 5400 (it fell from 5522 on Wednesday and ended the week near 5347), then it was likely headed for 5200.
I had believed that the greatest potential threat to stock prices was higher interest rates, even with Fed rate cuts. But a slowing economy seems to have reduced that concern. The danger in the months ahead is that if the economy slows, then any fiscal stimulus will widen an already enormous budget gap. The U.S. has been running massive deficits, even with a strong economy and low unemployment. If economic conditions force additional spending, then the risk of significantly higher Treasury rates, even with Fed rate cuts, could resurface. I wouldn’t wish that on anyone.
The stock market bulls now have stronger earnings on their wish list. The current second-quarter earnings season is winding down. It seems unlikely that any of the remaining reports (except perhaps Nvidia Corp. on August 28) will be of enough significance to have much impact on the overall market.
This week’s economic report calendar has far fewer announcements that have the potential to roil markets. The one exception is the unemployment claims report on Thursday morning. Last week’s market response to the Thursday and Friday employment numbers suggests we could see a big reaction on Thursday morning if the numbers come in much larger or smaller than expected.
| Economic Calendar (8/5/24 – 8/9/24) |
Previous |
Consensus |
|
| Monday 8/5/2024 | U.S. Services PMI, July |
55.0 |
|
| ISM Services, July |
48.8 |
51.0 |
|
| Tuesday 8/6/2024 | U.S. Trade Deficit, June |
$75.1B |
$72.5B |
| Wednesday 8/7/2024 | Consumer Credit, June, |
$11.3B |
$10.0B |
| Thursday 8/8/2024 | Initial Jobless Claims |
249K |
240K |
| Continuing Claims |
1,877K |
||
| Wholesale Inventories, June, M/M |
+0.6% |
+0.2% |
|
| Friday 8/9/2024 | No reports scheduled | ||
Links to previously published commentaries can be found at benjaminfedwards.com/Latest Investment Insights/Market Commentary/Market