Market Update: Signs of Unease Amid Bullish Sentiments

In my earlier days, when nights often ended in New York City bars, the end of Daylight Saving Time was like a little gift. Suddenly, 2 AM turned back to 1 AM, granting three more hours before last call. Now, however, the financial markets seem to be in a bit of a late-cycle unease, with Wall Street looking ahead to earnings season and the midterm elections hoping to reset the clock before the final bell.

It’s important to note that we are still in a bull market, as indicated by the unbroken uptrend of the S&P 500. There’s been a consistent rotation between AI tech and other sectors, with market pullbacks limited to about 3% over the last six months. Still, the index is hovering near a flat 50-day moving average, at levels that were only reached about 11 weeks ago. It’s worth mentioning that the AI hardware sector has faced challenges recently, bank stocks have seen poor performances following their earnings reports, and there are signs of distress in credit markets.

Last week saw a notable sell-off in semiconductor and data-center stocks that brought back memories of frantic market activity from July, when a major tech hedge fund was in the throes of liquidation. On Monday, a slight rebound in semiconductor stocks brought minimal reassurance, especially since it avoided the chaotic sell-off many anticipated over the weekend.

Jason Hunter, a technical strategist at JP Morgan, raises an interesting point regarding the mixed signals coming from the market:

“With the bearish seasonal window now closing, we are left wondering if the market is in the terminal phase of a sequence of rolling corrections ahead of a typical late-year rally. Or are the plentiful amounts of bearish internal, momentum, and intra-market divergences that have formed as the S&P 500 index has decelerated below longer-term channel resistance setting the market up for a larger and more correlated setback?”

He seems to suggest a cautious approach, keeping the S&P 500 on a short leash, with a 2.5% drop to around 7500 signaling a potential loss of confidence in the current market stability.

Historically, the market “should” be gearing up for a rebound — especially considering that the fourth quarter after a midterm election year has generally been quite positive. Earnings growth is projected to exceed a 20% year-over-year increase this quarter, which, on the face of it, bolsters the fundamental outlook.

However, one can’t ignore the shadow of 2018, marked by a significant downturn in the S&P 500 during a midterm election year despite a similar earnings growth narrative. That year featured a substantial rise and subsequent fall driven by momentum, exacerbated by the Federal Reserve’s tightening policies.

Currently, financial conditions are tightening as Treasury yields rise, corporate credit spreads widen, volatility increases, and the U.S. dollar gains strength. It’s often heard in investor circles that “the market is doing the Fed’s tightening for it,” suggesting that possibly the Fed should hold back on rate hikes, despite inflation’s uptick. Yet, the tightening observed in markets can, in part, be attributed to Chair Kevin Warsh’s commitment to fighting inflation, which leads investors to anticipate higher short-term rates.

How Warsh will respond to these shifts after the upcoming Fed meeting remains a topic of debate. Aditya Bhave from Bank of America points out that the markets are testing the Fed’s limits, with the Nasdaq down 5% and credit spreads widening. Some market participants interpret recent Fed statements as indicating a low likelihood of an interest rate hike in October, whereas Bhave holds a less conventional view, suggesting a possible hike.

On the other hand, Mike Wilson from Morgan Stanley argues for the need for the Fed to acknowledge current market tightening, believing it would be favorably received by sensitive market segments. Ignoring it, he suggests, could rekindle memories of the Fed’s previous rhetoric during tightening periods.

The trends of de-rating and de-risking are also noteworthy, particularly as smaller and cyclical stocks face valuation pressures and hedge funds divest from tech. The question looms: will buyers step in around or after the elections?

Pat Tschosik from Ned Davis Research mentions that their proprietary market-breadth indicator, Big Mo Tape, is tentatively showing signs of recovery from oversold conditions. He warns, though, that if Big Tech’s Q3 earnings disappoint, a full market washout could occur, potentially setting the stage for a post-election rally.

Market Temperature Gauge

John Kolovos notes a sentiment reset occurring in response to the unwinding of AI-related trades and tightening financial circumstances. While bullish sentiment is starting to wash out, he cautions that a break below the mid-September lows on the S&P 500, around 7,500, would suggest the beginnings of something beyond just a typical pullback.

Around the Street

• Interestingly, despite the bond market finally offering safer income options after years of low yields, investors still seem to prefer engineered income via options-selling ETFs. Some recent articles have explored these strategies, highlighting potential tax implications.
• Recent proposals from companies like Anthropic and Elon Musk regarding contributions to mitigate the adverse impacts of AI reflect growing concerns about economic disruption caused by technological advancements. While some may see these efforts as a marketing ploy disguised as benevolence, it’s reasonable to worry about the effects on the workforce.
• As Warren Buffett often suggests, perhaps a viable strategy against the encroachment of AI in the labor market is to enhance one’s skills and invest in personal development.

Market on Close

Historically, bull markets can endure well after they’ve been fully embraced and when stocks are no longer seen as undervalued. However, a number of indicators suggest that protections against unfavorable surprises are thinning out. Investors’ collective cash holdings as a proportion of total margin debt are considerably lower than they were back in 2000.

Still, various factors like long-short tax avoidance strategies are also at play, contributing to margin borrowing without true upside leverage. Investors often have their cash parked in bank deposits, which leads to high market exposure but decreased cash buying power.

A straightforward relationship exists in comparing equities and bonds; currently, the total shareholder yield is lagging behind the yield on the 10-year Treasury note, which suggests that equity risk may carry a higher threshold than it has over the last two decades.