The U.S. stock market is one step away from a chain of events that I think could mark the onset of a durable bear market.
The most common bull case I hear is that there is still too much money chasing too few assets – i.e., liquidity. Yes, there’s an enormous amount of money in our system, but that matters less than the fact the rate at which it’s coming in is likely peaking. The rate of liquidity entering markets has been slowing since the Federal Reserve fixed the rate of monthly bond purchases last summer. It’s not a coincidence the Nasdaq’s NDAQ trailing valuation has struggled since. Right now, the steroid boost of direct-deposit stimulus checks is waning, and the eventual drawdown of Covid-era unemployment benefits lingers. The next stimulus bill will be more politically difficult to pass and will likely have strings attached via taxes. Even if not, such “infrastructure” spending will likely show up more obviously in cyclical-stock earnings than broad market valuation froth.
At the end of the day, that’s what it all boils down to: froth. With practical-joke crypto tokens worth more than Chipotle and Ford’s market cap, it’s never been more obvious we’re in a tremendous risk-asset bubble. Crypto tokens are speculative assets and should be thought of as an extension of the stock market for all intents and purposes. The most important question is not what’s going to drive equity earnings from here, it’s what could create an opening for air to escape from valuations that have been the primary source of index gains since the Fed reversed rates in 2019.
We saw record ETF flows in the first quarter that added onto an astonishing one-year pace. That makes the market top-heavy. Some of the recent flow has gone into value-oriented companies, but after the huge amount of trading the past two quarters centered on momentum stocks, it follows that the average break-even price of investors is probably the highest it’s ever been.
And that’s where this precise moment has such potential to rock the boat.
A popular narrative around last week’s powerful bond rally is that it’s proof the Fed is in control. I’ve argued I think that case is flimsy. If the bond surge last week was simply a correction in the uptrend for yields, it means bonds can move again for any reason – growth, inflation or just because Treasuries are no longer reliably up-trending in price. Given the quality of recent economic data, odds favor the higher-yield trend. There’s been discussion about whether the level or rate of change for yields matters more, but it’s something in between. A move from 1.5% to 2% I think would be more problematic for the market than the move we had to 1.5%, because at least coming off the bottom, higher yields were in everyone’s framework. At 1.5%, with average economists’ estimates at 1.8% for year-end, there is much less room for surprise.
Another common thing I hear is that stocks have adjusted to the higher-rate environment and that recent gains in the indices reflect investors’ comfort with yields where they are. I think it’s more accurate to say that investors have been relieved that the yield went sideways and then lower.
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After last week’s simultaneous bond and stock rally, the 10-day correlation between the Nasdaq and the 10-year future is back near one. If the 10-year bond price drops again from here — just when investors think the Fed has lulled the market back to sleep — we should expect the Nasdaq to go with it. Growth funds like ARKK and MOON, the best proxy for the broader high-growth, high valuation universe, could break below support levels, enter formal technical downtrends, and create another leg of selling in the Nasdaq. These stocks have shown little sign of strength (apart from Tesla’s TSLA bitcoin bounce) during the market rally the past month. They look fragile. Also, the bearish signal in the VIX breakdown I wrote about earlier this year looks to be in play as the fervent call-buying of the quarantine period is unwinding.
Many have rightly pointed out that tech stocks need not inherently be tied to rates, but until the correlation breaks, why bet on momentum changing? Doesn’t matter if it’s rational or not, but so far the hardest-hit stocks since yields jumped are the most expensive, which is exactly what you’d expect. In February I used a simple price-to-sales analysis to rank what I expected would be the worst performers in a rate spike, based on what happened in 4Q19’s “quant quake.” It was nearly perfectly predictive. Newton’s first law adapted to markets: relationships in motion stay in motion until proven otherwise.
I do think economic growth will limit the speed at which the dynamics I’m describing could pull the market downward, but if the correction we’ve seen in Tesla and its high-growth peers turns into a full-blown trending bear market, there could be some very ugly patches. Last time it was easy for investors to pivot into the less-expensive stocks tied to the economy, but, as we see in the recently stagnant Russell 2000, such rotation may not be as powerful this time.
That said, cyclical stocks would still probably be the best bet for U.S. equity-constrained investors. Progress being made on the economy will help offset valuation compression through earnings growth in these companies. In other words, the bearish dynamic I’m warning of in all this could end up being specific to the Nasdaq. It’s possible the Russell 2000 and maybe even the S&P 500 could diverge substantially from the Nasdaq for some time.
I’ll know I’m wrong if yields have a meaningful move higher from here and the Nasdaq does not go down. It should also be noted there’s a difference between the peaking liquidity argument I lay out vs the rate-drive panic as the driving force. If weakness is more a function of liquidity running drier, bonds could firm as the market slows down and rolls over. I think we’ll know if liquidity is at play if bitcoin is pulling back alongside the market. Bitcoin is the purest speculative liquidity-driven trade, and we should expect stock valuations to move in sync with bitcoin. If it’s rates and inflation fears that drive equity selling, bitcoin may still have a chance to work in that scenario. I personally don’t think it will, but I’ll wait for more evidence. It would be bitcoin’s big chance to prove itself as having macro ties beyond speculation. More on that later.
Bottom line: the market looks strong at all-time highs, but there are too many risk points to keep gliding higher. Many stocks are above their moving averages but the number at new 52-week highs in the Nasdaq has been trending lower since November. The latest leg of the rally was effectively a rolling bid away from multi-year winners in the growth cohort to high-quality “defensive” tech, then utilities, staples, healthcare, and low volatility ETFs. One way to think about this is the market desensitizing itself to interest rate risk. It looks more to me like investors are playing musical chairs after getting shocked by the rate-driven selloff in February. If that dynamic reappears it may induce panic.
I wrote in February that stock bulls face the Final Boss in interest rates. If the bounce in yields from here happens and the dominoes don’t fall the way I expect, then I have nothing left to say but “buy.”