We all like to search for the underlying causes behind a market move. Some days, the catalysts are obvious. Other days, not so much. Over the years, I’ve fielded many calls from reporters who were struggling to find a narrative to explain a day’s market activity, only to struggle to offer one of my own.   

I have spent the bulk of my career in search of tradeable cause-and-effect situations. I was a systematic trader before the term morphed into the more sophisticated-sounding algorithmic trader. The Holy Grail is a foolproof system where a stable set of inputs results in a predictable set of outcomes. In theory, this seems easily achievable. In reality, it’s incredibly difficult.If it was easy, hedge funds and other trading firms wouldn’t need to employ teams of quantitative experts to find and refine those relationships. 

A big hurdle is that markets need to continuously deal with exogenous events and that investors’ reactions to those events are filtered through human psychology. Emotional reactions are incredibly difficult to model, however. So are expectations, or more specifically, knowing which expectations are already discounted by investors and which are not. A skilled equity analyst may come up with a detailed rationale for why a company should be expected to earn 60 cents this quarter. Yet if the company actually reports 60 cents, the market reaction is still an open question. Were investors really hoping for a penny or two more? Does the company’s management offer a positive or gloomy outlook for the coming quarters? Is there a big upsurge or downswing in the broader market that renders the results somewhat irrelevant that day? And how do we model investor reactions to all those questions?

Despite those problems, markets still seek narratives anyway. A common one for stock investors is to follow 10-year Treasury yields. But stock investors can read the messages from the bond market in various ways. Let’s consider the relationship between the 10-year and the NASDAQ 100 Index (NDX), pictured below. We have heard the rationale that investors should be favoring the mega-cap tech stocks that dominate NDX when rates fall because lower rates mean that the present value of those companies’ future cash flows increase when they are discounted at a lower long-term rate. There is truth to that logic, though I have frequently questioned whether investors in those stocks are actually concerned with valuation. 

6 Month Chart, 10 Year Treasury Note Futures (candles) vs. NDX (blue)

Source: Interactive Brokers

Earlier this year, NDX was roughly correlated with 10-year prices.(Remember, bond prices move inversely to yields). Yields rose throughout most of the first quarter, during which time NDX rose, then fell. During the second quarter, NDX rose and fell even as yields steadily declined. Was the pattern simply a matter of timing, with NDX rising early in the quarter before retracing some of those gains as the quarter progressed? One would be tempted to draw that conclusion, despite the narrative about tying mega-cap stocks to rates (by the way, if that pattern holds, we could be in for a rocky summer). Yet over recent sessions, the narrative seems to have flipped upside down:

1 Month Chart, 10 Year Treasury Note Futures (candles) vs. NDX (blue)

Source: Interactive Brokers

Note the sharp spike in NDX over recent sessions even as bond prices fell. Somehow, the logic flipped, with lower yields reflecting economic worries and higher yields reflecting more economic confidence, which is good for tech stocks. So, slower growth is good for tech stocks when it can lead to higher valuations, and faster growth is good for tech stocks because they can earn more. Heads I win, tails I win. Rather than stocks following the narrative, the narrative appears to be changing to fit the outcome.

My explanation is simpler. The bond market narrative is convenient for explaining day-to-day moves because it can and does explain the moves that occur on a given day from time to time. But the far more stable relationship is displayed in the graph below. Bottom line, the Federal Reserve keeps adding monetary stimulus, some of which finds it into stocks, with most of the money that flows into stocks going to the biggest stocks in the market – the mega-cap tech shares. 

Federal Reserve Balance Sheet (top, white), NDX (top purple), with Absolute and Percentage Changes (bottom, red, blue)

Source: Bloomberg

The bottom line, this is the underlying narrative that appears to matter most. We can search for a narrative that fits on a day-to-day basis, but the one that works best is more immutable than malleable: as long as investors perceive that the Fed will keep the money flowing, it should be supportive of stock prices. If that perception changes, so should that narrative.