It’s Not a Problem Until It Is

Like many of you, I woke up this morning to see US markets sharply lower and wondered why. Usually, there is an obvious cause for a market drop or a “flight to safety”, but today’s rationale is somewhat nebulous. Did the renewed state of emergency in Tokyo remind investors that Covid still remains a significant problem in much of the world? Could the relentless drop in 10-year US Treasury yield indicate that the US and/or global economy is not as robust as many assumed? Did the recent rally in the mega-cap technology shares that dominate the index weight of the Nasdaq 100 (NDX), and to a lesser extent the S&P 500 (SPX), mask some fault lines in the broader market? Might the recent drop in meme stocks have portended a change in speculative sentiment? To some extent, the answer to all those questions is “yes.”

The Nikkei 225 (NKY or N225) has been signaling weakness for some time. The index last hit a high in February, when it was big news that it had recouped the 30,000 level for the first time in decades. Since then we have seen SPX move more or less steadily to higher heights, while NKY has seen a pattern of lower highs and declining moving averages. This is demonstrated in the chart below:

Year to Date Daily Graphs of Nikkei 225 (NKY, candles, left scale) and S&P 500 (SPX, blue, right scale) Indices with 10, 30, and 50 Day Moving Averages and Ratio (bottom)

(Click on image to enlarge)

Source: Bloomberg

A divergence of this type need not indicate trouble. Major global indices can and do diverge for extended periods of time without incident. But part of the recent investment narrative has been about a synchronized global economic recovery. It appears that investors in a G7 country have not fully agreed with that theme.

Nor does it appear that bond investors are fully embracing the narrative of a strengthening global recovery. Remember that Treasury yields reflect economic and inflationary expectations, so one can reasonably assert that the recent drop in yields reflects a drop in those expectations. But which ones? 

Year to Date 10-Year Treasury Bond Yields, Daily Candles with 10, 30, 50 Day Moving Averages

(Click on image to enlarge)

Source: Bloomberg

Inflationary and economic expectations usually go hand-in-hand, but the recent narrative from the Federal Reserve might have clouded that picture. A valid interpretation of the commentary since the last FOMC meeting and yesterday’s meeting minutes could allow bullish bond traders to believe that the Fed is engineering a Goldilocks recovery, one where growth occurs against a backdrop of little to no inflation. That is possible, of course, but difficult to achieve. The simpler explanation, which is far less market-friendly, is that both bond and stock investors overshot their expectations for economic growth. For today at least, the latter explanation seems to be in place. That said, I believe that much of the recent movement in bond prices is also the result of momentum trading in futures markets, which has caused the 10-year to overshoot a rate rise in the first quarter and overshoot a decline since then.

The dip in 10-year yields has been used as a rationale for buying the most highly valued technology stocks. The logic is that since stock prices are meant to represent the present value of a company’s earnings and/or cash flows, a lower discounting factor (lower bond yields) allows for higher valuations. I have believed that this is more an ex-post rationale for historically high valuations in these stocks, but the valuation argument is a pervasive one. When we bear in mind that the top 7 companies represent over 50% of the market cap in NDX and about 25% of SPX, anything that is good for those stock prices can’t help but be good for those indices. (The reverse is also true, of course). The relentless rise in SPX and the recent outperformance in NDX have masked the narrowing leadership as these indices have reached new highs. 

Having said all that, today’s downdraft may simply be a one-day phenomenon. We have seen days like this frequently over the past year and a half, where risks come to the forefront and traders fret for a while before deciding that this dip, like so many others, is a buying opportunity. Bear in mind that even at today’s lows SPX was only flat for the month to date. Also, we have seen some gains since European markets closed. Time will tell if today’s drop is a one-day wonder or something more important. At a minimum, however, today serves as a reminder that risk is always lurking out there somewhere – even if traders are conveniently ignoring it.