Broker Check

What’s Causing the Increased Volatility in Stocks last week??

August 09, 2023

The S&P 500 dropped moderately last week for the first time in months, and the main “reason” for the decline was the spike in longer -dated Treasury yields, as the 10 year approached one-year highs before falling off on Friday following the jobs report.

Stepping back, while higher yields (along with some lackluster earnings last week) were legitimate headwinds on stocks, the real reason stocks dropped last week is because of valuation. The S&P 500 trading above 4,500 is priced for a near-term perfect scenario, and that’s not what we got last week. So, even modest negatives (the uptick in yields and lackluster earnings) can cause a pullback, not because they are that bad in an absolute sense, but instead just because there’s no margin for error at current levels in the S&P 500. Those general valuation issues are why stocks drifted lower Friday afternoon, despite the decline in yields.

More to that point, as we and others have said, the rally to current levels in the S&P 500 has been driven by better-than-feared fundamentals, but also by a healthy dose of “chasing” and money flows as under-exposed investors added stock exposure, as very negative sentiment turned positive.

Now, that dynamic has been exhausted, and many investors (and analysts) are simply assuming everything will work out, earnings will stay stable, the no/soft landing is inevitable, Fed rate hikes are over (and cuts are coming) and it’s just a matter of time until the S&P 500 hits fresh highs. Point being, the negative sentiment that laid the foundation for the big YTD rally is gone, and in its place is a near-term vulnerability if news or data isn’t constantly positive. That’s what happened last week, and stocks dropped as a result.

And because of this dynamic, if we get more “not positive” news over the next few weeks (economic data softens, inflation is hotter than expected, corporations warn on Q3 earnings) then a continued decline in the S&P 500 back towards more fundamental support (4,300 -4,400) makes sense and should not be a surprise!

Positively, though, as long as the “Three Pillars” of the rally (No/ Soft Landing, Disinflation, Fed Almost Done with Hikes) remain in place, then any decline to 4,300-4,400 (or close to it) would not mean this rally was about to meaningfully reverse.

That said, while fundamentals remain broadly supportive (as long as the three pillars are in place) for in- vestors that were looking to potentially reduce long exposure in the near term, it’s not a bad place to do it as valuations are stretched. To be clear, I’m not advocating going underweight stocks or massively raising cash. I do still recommend that we stay conservative in defensive stocks to weather this storm.  But to be clear, I’m not saying the 2023 rally is over and about to reverse, because fundamentals re- main supportive of the S&P 500, broadly speaking.

Bottom line, the market remains largely priced for near perfection, and last week wasn’t perfect. And if that happens again this week, we should expect a further decline in the S&P 500. However, as long as the three pillars remain in place, then any pullback should be viewed as a decline in a still positively trending market.

Broadly speaking, last week’s economic data largely maintained the “Goldilocks enough” trend of the past several weeks, and as such it didn’t undermine any of the current soft/no landing expectations that have helped support stocks since June.

However, over the past week, solid economic data has put upward pressure on Treasury yields, and if yields continue to rise it will exert more pressure on stocks, so going forward investors will want to see a bit more moderation in the data to take upward pressure off yields.

Looking at the jobs report, there were hints of “Too Hot” but they were small, and the headline job adds helped to make this report (barely) Goldilocks enough. The headline job adds were slightly under 200k and there was a downward revision of 24k to the June economic data, underscoring that we are likely seeing some softening in the labor market (although it remains broadly healthy). But that was countered by a drop in the unemployment rate to 3.5% vs. (E) 3.6%, and an uptick in wages (up 0.4% vs. (E) 0.3% and 4.4% y/y vs. (E) 4.2% y/y).

But neither of those numbers were materially above expectations, and the drop in job adds combined with fact that stocks were coming off two down days and the 10- year Treasury yield was due for a breather helped to keep the market reaction to this report largely muted (futures were slightly higher before the report, and were slightly higher an hour after the report).

Bottom line, the market gave this jobs report a “pass,” but if we see more reports like this, where unemployment and wages are firm but we see deteriorating job adds that will increase stagflation worries, so we’ll continue to watch labor trends closely in the coming weeks (including claims and the employment data in the August PMIs).

In sum, the July ISM PMIs largely reflect a stable economy, and while the data is showing some loss of momentum, specifically in the services sector, there’s nothing in the July PMIs to invalidate the soft/no landing thesis. That said, the service PMI is drifting somewhat closer to the 50 level, and if it does break that level (which doesn’t happen often) that will be a clear, negative signal and it’ll increase hard landing worries.

I believe this reinforces our conservative approach to stocks for the foreseeable future. In July we had a huge move of money into the very stocks that we hold. I don’t think that trend will end and will reward us for our patience.

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