We have been watching the broad U.S. stock market’s internal technical condition over the past few weeks and have pointed out the divergence between market cap-weighted indices (that investors often reference) and everything else. Simply put, U.S. equities have been flashing warning signs for the past month. Leadership is confined to a few sectors and a few large companies. Furthermore, that leadership has been shrinking.
All the while, bond yields continued to fall. The bond market usually gets it right. The media keeps screaming that we are headed for rampant inflation, which will cause the Fed to raise interest rates and put the brakes on the economy. They say that this inflation threat is the gorilla in the room and is causing stocks to fall. If that is so, then why are bond yields dropping almost as fast as they rose earlier in the year? Inflation typically causes interest rates to rise, not fall. This inflation “bogey man” does not match up with what the bond markets are saying. All things being equal, I will take the bond market every time. What does make sense, is that we are long overdue for a pullback in equities and a bounce in bonds. We have had nine months of unfettered advances in stocks.
Bull markets are made up of two steps forward and one step back. We have been taking two steps forward every month without a step back. Some of this is the result of the unbelievably unique circumstances that have come from Covid-19 and the world reopening after last year’s shutdown. Be that as it may, it sure feels like the straight up move in major U.S. indices is and has been on borrowed time. Our past few commentaries have alluded to this, and we suggested that we would soon know whether “other stocks” are going to find their footing and catch up to those leading sectors and stocks, or if those leaders are going to slip. That question seems to have now been answered, as it appears a correction has begun.
The market is down almost 4% (SPY) in four short days and is now testing its 50-day moving average. Should investors fail to step in here and kick this correction down the road, we can likely expect some volatile trading and a drop of another 4-6% over the next few days and weeks. At the same time, the economy looks great. Earnings were expected to be good, and they have thus far come in even better. I expect that trend to continue as we approach full employment and supply chain issues are resolved.
So, what do we do with all this information? We know earnings drive price. We know that if earnings continue to rise, price will follow. Inflation kills bull markets by causing interest rates to rise to the point that companies can no longer grow earnings. That is certainly not the case today. It could be the case tomorrow or next week, but not today.