Wall Street’s Resilience in Stocks

After the summer lull, Wall Street is back and appears more committed to stocks than ever before.

The S&P 500 has managed to maintain its upward trajectory. Last week, a slight pullback came close to revisiting the highs from May to July but didn’t quite cross that threshold. Surprisingly, despite potential reasons to drop more significantly, the index has kept corrections subtle and somewhat hidden.

This stability points to strong support for equities from professional investors. They seem unshaken by common warnings about weak seasonal patterns typically seen in September and October. Or maybe they just feel any declines in these months usually get corrected in the fourth quarter.

Various measures of investment risk and equity exposure from firms like Goldman Sachs, State Street, and others indicate that investors are well-prepared for fall.

Moreover, the Leuthold Group’s Courage/Fear Ratio has hit an 18-year peak, highlighting a tendency among investors to favor riskier assets over safer ones.

However, Barclays strategist Venu Krishna remarked that individual investors are showing less enthusiasm lately. Retail participation seems to have cooled off, suggesting that this recent surge in interest might be more institutional than driven by individual traders.

This ongoing caution aligns with an emphasis on earnings growth among professionals, which continues to be a major factor boosting confidence. Still, there are concerns about large companies potentially overstating profits due to shifts from AI-related capital expenditures. The Cboe S&P 500 Volatility Index (VIX) remains low, below 15, a state that may influence some major quant models to stay on the anxious side.

Interestingly, some key concerns are yet to fully materialize. Worries over shaky economic conditions in the U.S. that could make a Federal Reserve rate hike seem ill-timed were tempered by solid data recently, including a robust payroll report.

Furthermore, skepticism regarding the speed and sustainability of the AI investment surge lacked any concrete evidence during earnings season, as many companies raised capital expenditure forecasts and provided optimistic guidance.

Rising Bond Yields: A Double-Edged Sword?

Nevertheless, both strong economic growth and consistent AI investment are fueling a primary concern for investors: the rising bond yields.

The upward trend in 10-year Treasury yields towards 4.8% can be viewed as a “normalization shock,” where rates return to levels seen before the global financial crisis. Historically, rising yields have negatively correlated with stock prices.

As mentioned previously, these absolute yield levels can coexist with a robust equity market. However, the context changes since we’ve seen yields rise from nearly 1% six years ago. Today’s 4.7% yields imply that many bonds issued in recent years are now trading below their issue price, leading to investor caution about fixed-income assets—especially now that bonds offer decent returns again.

Jim Reid from Deutsche Bank points out that it’s becoming tougher to realize outright negative returns on government bonds over a more extended period. So while the headlines might remain negative, at least bonds are acting like bonds again.

Historically, during the last sustained period of contrary moves between yields and equities, a 60/40 stock-bond portfolio—like the Vanguard Balanced Index Fund—postured strong returns. Between March 1990 and March 2000, it delivered 14.8% annualized return, surpassing the S&P 500’s returns during that time frame.

In contrast, the past decade offered a different narrative, where bond prices largely countered stock weaknesses, making the Vanguard fund yield only about 61% of S&P returns. This disparity occurred because starting yields were significantly lower than they are today.

While it’s certainly possible for bond markets to worsen from this point, we are approaching the Fed’s next meeting with debated odds on whether to raise rates or hold positions. Inflation data could play a pivotal role, with fluctuating oil prices and global fiscal challenges narrowing the outlook.

However, having higher yields can serve as a buffer against unexpected fluctuations, particularly if market conditions shift more abruptly than what investors currently anticipate.

Market Conditions Overview

Turning back to the ongoing developments, the commitment to AI investments remains evident among companies involved in this sector. How this investment trend unfolds, however, is still somewhat unpredictable.

Since the end of June, Nvidia outperformed the overall semiconductor sector by 35 percentage points after lagging behind for nearly a year. Meanwhile, software stocks have rebounded significantly from the “Saaspocalypse” sell-off earlier this year.

Nvidia’s recent acquisition of the AI development platform, Hugging Face, and Meta Platforms’ advancements in open-source AI suggest a shift towards AI adoption rather than just construction.

Of course, there are signs that memory stocks might be struggling to break free from their protracted downtrends, while AI-related industrial stocks, reliant on extensive order backlogs, appear somewhat exhausted.

Still, the primary reason key indexes are holding near their all-time highs is the resurgence of shares from major tech players.

The iShares Nasdaq Top 30 Stocks ETF embodies this trend well, surpassing the performance of the narrower Magnificent 7 group.

In essence, the broader index of “QTOP,” which includes the Magnificent 7 and essential semiconductor stocks alongside other significant corporations leveraging AI, saw its peak during the May-June run-up preceding the SpaceX IPO. Since then, it has seen significant swings but remains about 5% below its earlier high. If it doesn’t start achieving new highs soon, the momentum driving this AI-fueled market rally may start to wane.