The US stock market’s self-defense mechanism is running full blast

One of the oldest — and truest — market axioms is that in a crisis, correlations go to one.

That means when conditions take a meaningful turn for the worse, everything in the stock market goes down together.

Right now, we’re in the midst of one of the longer streaks in history without a 2% decline for the S&P 500: 321 sessions and counting. Amid this streak, the VIX Index — a gauge of the how volatile the S&P 500 is expected to be over the next month — recently hit its lowest levels since 2019.

A big reason for this sense of calm in the stock market has been because major subgroups haven’t been moving strongly in the same direction on a daily basis. For instance, the three-month correlation between the daily change in bank stocks and tech stocks is about 20% — while in 2022 it reached above 80%.

Think of it like a winning sports team: If the star player (Nvidia) pulls a hamstring, the rest of the role players and bench players (banks) need to step up, or else it’s game over.

This dynamic of protective rotation in the internals of the equity market — some groups doing well while others struggle, preventing big downside at the index level for US stocks — was in place for much of 2023. But what’s changed for the better is the perceived riskiness of other asset classes — particularly bonds. Last year, discussions surrounding the Federal Reserve was about how much they would have to hike interest rates, and if doing so would lead to a nasty recession. This year, it’s more about whether the Federal Reserve will cut once or twice into an economic backdrop that remains pretty solid. That’s allowed volatility across asset classes to move lower.

Relentless market rotation was most intense in 2017, which was without a doubt the most boring year for equity markets in history. There was no volatility, no big moves... stocks just drifted higher. Great for your 401K; terrible for those in my line of work. I had to half-heartedly pretend that things like the attempt to repeal the Affordable Care Act would be a potentially major catalyst for US stocks. 

But what’s completely different this time is the relationship between these different groups and interest rates.

In 2017, banks would tend to do better during days in which bond yields rose, as this was seen as a signal of improving economic growth prospects, and would get bludgeoned when bond yields fell. Now, banks aren’t doing too badly on days when yields decline. That’s because interest rate cuts are viewed as something that won’t be needed to arrest a free-fall in activity, but rather as a salve that will kick some of the struggling cyclical parts of the economy into a higher gear.

Meanwhile, these days tech stocks are still doing relatively well when bond yields are rising — because no matter whether the risk-free rate is 4% or 5%, that’s a rounding error compared to the return potential associated with AI, in the minds of corporate executives. That kind of spending does not appear to be that rate-sensitive — especially because the companies with some of the biggest AI capex outlays are sitting on piles of cash in the form of retained earnings. 

Back in 2017, the narrative was more about high yields being a headwind for expensively-valued tech stocks, because so much of their earnings potential was in the future not the present (and would need to be discounted by this higher interest rate). 

Another key way in which this story only rhymes with but doesn’t quite match the excruciatingly low-volatility world of 2017 is that these individual groups are, on their own, moving much much more. Their moves are just offsetting one another.

“The difference between now and 2017 is when bond yields were so much lower we didn’t even have these under surface swings like we do now,” said Dave Roberts, independent trader. “Indexes are fine now, but names and sectors are still moving a lot more than 2017.”

It’s like a duck: the illusion of calm on the surface of the water belies the furious paddling going on underneath.

The KBW Bank Index and the Invesco QQQ Trust Series 1 ETF (which tracks the Nasdaq 100) have had a daily gain or loss in excess of 1% on 74 occasions so far this year. Compare that to 88 instances for 2017 as a whole.

Putting this together, this suggests that if indeed we do get more of a “correlations to one” moment for the equity market, it could be quite a bit more disruptive than the down days were in 2017 — as the likes of tech and banks have already demonstrated they’re primed to move.