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By Pete Biebel, Senior Vice President

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We don’t need a detective to explain how well the U.S. stock market has rewarded investors in recent months. We’ve all witnessed the progression of record highs in the major averages. The footprints in that track higher show evidence of just two brief stumbles that arrested headway along the path, one of which came just last week.

The averages were flat-ish through the first two sessions of the week, but they got ambushed Thursday morning. Stock index futures were showing pre-opening losses of 1.5% to 2+%. Various culprits were alleged to have been responsible for the attack. One convenient target of blame was the increasing rate of infections involving the COVID Delta variant. Another was news of China’s crackdown on cryptocurrency mining. It seems that, when the market needs an excuse, COVID and China are often among the usual suspects.

Also on the list of possible perpetrators was disappointing economic data. While futures were already steeply in the red prior to the announcements, weaker than expected reports on Construction Spending and the ISM Services Index abetted in the larceny. The Construction Spending data for May came in at -0.3% against expectations of +0.5%. The ISM report for June was expected to show a modest decrease to 63.3 from its May reading of 64.0. The reported number was a surprisingly low 60.1, suggesting the services sectors of the economy are continuing to improve but at a rapidly decreasing rate.

But the most obvious smoking gun was the bond market. The yield on 10-Year Treasury Notes had been trending lower through the Spring since peaking just above 1.70% in March. That rate was hovering around 1.60% as recently as early-June. It had slipped to about 1.45% as July began, and was still near that level when last week began. Following the holiday weekend there was a rush of buying in Treasuries. Some of it may have been driven by fears of slowing growth in our recovering economy. Much of it was likely forced buying by traders who had shorted Treasuries in the expectation that rates would rise. An article citing a J.P. Morgan survey on Tuesday of last week reported that net short positions in Treasuries were near their highest level in well over a year. That short-covering type of buying tends to feed upon itself. Regardless of the source, the surge of buying pushed prices higher and drove the 10-Year yield down to 1.3% by Wednesday afternoon. Before stocks opened on Thursday, that rate had plunged to 1.25%.

It’s no secret that the big swings in the longer end of the Treasury market have had a significant impact on the relative strength of various sectors in the equity market. As the 10-Year yield declined in recent months, growth stocks enjoyed renewed strength and recovered the steep losses they suffered when that yield spike higher early in the year. So, we might have expected a mixed bag of performance when rates spiked lower Thursday morning. Instead, there was an almost unanimous verdict. All U.S. equity sectors gapped lower that morning; only the Utilities sector managed to climb back into the green later in the morning.

The inexplicable action in the bond market seemed to handcuff the stock market. What misfortune in our future might this sudden steep decline in rates foretell? Fortunately, as the day went on, stocks recovered. Most sectors saw their lows of the day in the opening hour that morning; several made their lows in the opening minutes. Returning to their prior modus operandi, growthier sectors like Consumer Discretionary and Technology recovered substantial portions of their morning losses by the close that day. Conversely, the “recovery” sectors Consumer Staples, Industrials and Materials ended near their lows.

Thursday morning also saw the low (so far) in the 10-Year yield. It rebounded to about 1.29% late that day and continued higher on Friday, ending the week near 1.36%. The recovery in that benchmark yield provided a motive for stocks to rebound as well. The major averages all gained something around 1% on Friday, which was just enough to lift them to net gains for the week. The NASDAQ Composite Index (COMP) and the S&P 500 Index (SPX) each tacked on about 0.4% for the week while the Dow Jones Industrial Average (DJIA) added a bit more then 0.2%. The Russell 2000 Index of small-cap stocks (RUT) leapt more than 2% on Friday, but still carded a net loss for the week of about 1.2%.

As I indicated in my opening paragraph, last week’s pothole was the second such brief but violent interruption in the market’s recent gains. On Friday, June 18th, in the wake of the Fed meeting earlier that week, the major averages plunged by between 1% and 1.5%. It was the first, and until last week, the only interruption in the climb from the mid-May. And, as was the case last week, all those losses were wiped out in the next session. It seems that the surest way to get a 1+% gain is to have a 1+% loss the day before.

In my most recent article, two weeks ago, I described how SPX had finally been able to cross out of a long trading range.  I theorized then that the next target range for the index would be in the 4335 to 4375 range. In the week that followed, SPX continued its breakout rally and hit a high on the Friday before the holiday weekend at 4355, smack dab in the middle of that range. The index closed that day and week just a few points lower at 4352. In that same article, I also theorized that “If the index is going to be able to climb into that range, it will likely need continuing help from the three sectors that hit new highs last week: Communication Services, Healthcare and Technology.” Technology was, in fact, the best performing sector in the past two weeks with a gain of a bit more than 4%. Healthcare was third-best over that stretch, up about 2.5%, just behind the 2.7% gain in the Real Estate sector.

While the return of the domination of the mega-cap tech stocks has clearly helped the overall market in its climb, lately it has been masking a deterioration in the market’s breadth. Many of those big-name stocks are just now finally exceeding their highs of last summer. They spent eight to ten months consolidating their gains of the first half of 2020. Recently, with the help of declining interest rates, many of those stocks are breaking out to new highs. The eight largest are responsible for more than half of the gain in SPX since the May low. But that’s largely why market breadth statistics like advance/decline ratios and new highs versus new lows have been making lower highs, diverging from the overall market’s higher highs.

That divergence is a negative omen, but not necessarily the end of the climb. In the week ahead, I’ll be watching to see if SPX, which ended last week just below 4370, can see sustained trading above the 4375 level. If we get two or three relatively flat days, check the advance/decline numbers.

This week brings a very long and very varied list of potential catalysts for market volatility. The new earnings season launches this week. A squadron of big banks will lead the charge. The reaction to their announcements might be especially telling in light of the steeper yield curve through much of the quarter and results of the recent Fed stress test. The economic report calendar includes numerous potential market movers. The CPI and PPI numbers will very likely generate some pre-opening volatility on Tuesday and Wednesday morning. Thursday brings several reports on manufacturing activity with mixed expectations. Traders will be looking for significant month-over-month improvement in the Retail Sales numbers on Friday morning.

One other potential midweek landmine is a trio of scheduled policy decisions from central banks in Canada, Chile and New Zealand. All three are expected to announce some tightening steps through either a reduction in asset purchases or an increase in their target lending rates. Their actions are unlikely to have much impact on our Fed’s policies, but the greater the extent of their adjustments, the more they could impact our markets’ concerns that the Fed might eventually be forced to take action sooner than advertised.

 

 

Date Report Previous Consensus
Monday 7/12/2021 No Reports Scheduled
Tuesday 7/13/2021 NFIB Small Business Optimism Index, June     99.6      99.2
Consumer Price Index, June, M/M    +0.6%     +0.5%
CPI ex-Food & Energy, June, M/M    +0.7%     +0.5%
Wednesday 7/14/2021 Producer Price Index, June, M/M    +0.8%     +0.6%
PPI ex-Food & Energy, June, M/M    +0.7%      +0.5%
Fed Beige Book
Thursday 7/15/2021 Initial Jobless Claims    373K      368K
Philadelphia Fed Manufacturing Index, July     30.7       28.5
Empire State Manufacturing Index, July     17.4       18.3
Import and Export Prices, Imports, June, M/M    +1.1%     +1.2%
Import and Export Prices, Exports, June, M/M    +2.2%     +1.3%
Industrial Production, June, M/M    +0.8%     +0.7%
Friday 7/16/2021 Retail Sales, June, M/M     -1.3%      -0.4%
Retail Sales ex-Vehicles & Gas, June, M/M    -0.8%      +0.3%
Business Inventories, May, M/M    -0.2%      +0.4%
Consumer Sentiment, July      85.5       87.0

 

Links to previously published commentaries can be found at benjaminfedwards.com/For Our Clients/Educational Resources/Market.

July 12, 2021 |