It’s a Macbeth market: full of sound and fury, signifying nothing
Volatility markets and credit markets are at odds. And the stock market disagrees with itself.
The good news: the wounds inflicted on global markets this week look a lot more technical than fundamental. The bad news: the wounds inflicted on global markets this week look a lot more technical than fundamental – so far.
Volatility markets and credit markets – which typically behave the same way in times of financial stress – are completely at odds. And in the equity market, investors can’t make up their minds whether to focus on rotating out of megacap tech into more cyclical parts of the market, or seeking safety in defensive sectors as recession fears creep higher.
If the dust from recent mechanical, panic-induced selling dissipates, the backdrop could look fairly benign before long. The S&P 500’s earnings expectations are still improving, profit results are largely beating expectations, and investors may grow more confident that easing from the Federal Reserve will stabilize the labor market and the economy before long.
But it’s also easy to take off the rose-colored glasses and see a more perverse future. If the outlook for the US economy continues to soften, cyclical parts of the market might have a lot more downside – just as investors are beginning to question the ROI on AI spending.
The challenge for investors in the coming days and weeks will be the search for cohesion in a Macbeth market, where the price action has been full of sound and fury, signifying nothing.
With the S&P 500’s fear gauge hitting levels only seen during the 2008 financial crisis and the 2020 pandemic, the signal from volatility markets is that the world is on fire. But the credit market continues to say it’s fine. The surge in the VIX Index on Monday was accompanied by a relatively tepid widening in credit spreads.
More important than the one-day moves are the absolute levels these metrics finished at during Monday’s rout. The VIX ended the session at its 96th percentile relative to history (i.e., it’s only been higher on 4% of sessions going back to August 2000). High-yield credit spreads are in their 33rd percentile – in other words, investors are usually much more worried about the potential for a wave of corporate defaults than they are now.
For better or for worse, the US stock market remains tethered to Japanese assets right now. When US stocks have a stronger connection with Japanese assets than with US credit markets, your eyebrows should go up: this is definitely not normal.
Speaking of abnormal, we have the completely muddled internals of the US equity market.
On the one hand, the Financial Select Sector, Industrial Select Sector, and SPDR S&P Regional Banking ETFs are all closer to their 52-week highs than the Nasdaq 100. This is a market that still bears a lot of the hallmarks of the “rotation” narrative that was in full swing in early to mid July, when a narrow, AI-dominated market shifted into one with more breadth, with small caps and more cyclical stocks performing well.
This isn’t what markets trade like when recession worries are ascending.
“If company fundamentals are in decent shape, this begets the question as to whether valuations have to now re-rate lower because a recession is more obviously on the horizon today than it was in April,” writes Michael Purves, founder of Tallbacken Capital Advisors. “Our view is this question will haunt cyclicals and the ‘rotation equities’ much more so than it will haunt the big tech indices.”
That being said, tech companies are the most expensive part of a richly valued market, and the bar for them to attract more love from investors seems to be high. With six of the so-called Magnificent Seven having reported results so far this season (all save Nvidia), the average member has fallen 3.6% the session after releasing their quarterly update.
On the other hand, defensive, rate-sensitive sectors are trouncing the US stock market as a whole, something that is generally seen when risk aversion and fears about the economic outlook are high.
Utilities, for instance, have outperformed the S&P 500 by more than 9% over the past two weeks. That’s 99th percentile outperformance. The only times we’ve seen this defensive sector do even better than the benchmark US stock gauge has been during bear markets (March 2022 and the 2008 financial crisis) or relatively deep equity market drawdowns (2018, early 2016).
And investors seem to doubt that consumer-centric parts of the equity market will be able to maintain their recent operating performance – in large part because these companies sound circumspect, if not gloomy, about the road ahead.
“Many clients have fixated on downbeat commentary about the US consumer from select corporates,” writes Goldman Sachs chief US equity strategist David Kostin.
Kostin flagged how consumer discretionary that have exceeded expectations on quarterly profits outperformed the S&P 500 by a paltry 0.2% the following session. Normally, stocks that beat earnings estimates go on to best the benchmark US stock gauge by 1%.
It’s going to take time to wrestle through these competing narratives and mixed messages.
“Our sense is the market will stay violently flat – little direction at the index level, but lots of internal realized vol – until the breadth of data can allay recession fears,” writes Dennis DeBusschere, chief market strategist and founder of 22V Research. “We’d be surprised if the market melted down because of the one payroll reading.”
Stepping back, it’s a complete mess out there. And a market that doesn’t make too much sense is probably a market you shouldn’t try to make too much sense of.
