Interest Rates Created a Two-Tiered Market. Earnings Will Test It.
Oversold conditions and positive seasonality look promising, but we still need price action to confirm a turn.
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Market action is quiet early Monday morning as investors contemplate the events that unfolded in the third quarter. We had unusual technical conditions and uncommon price action. The challenge for investors will be determining how some of the most extreme action reverts as we move into third-quarter earnings.
The most notable development in the third quarter was the sharp rise in interest rates and the drop in bonds. The 10-year Treasury yield rose from about 4.47% to 5.28%, the biggest quarterly increase since 1994.
Typically, such a sharp increase in interest rates is quite negative for stocks, but the response this time was unusual. Big-cap AI-related stocks barely reacted. Those stocks dominate the weighting of the S&P 500, and as a result, the index is only about 1.25% from the all-time high it hit in August.
That sounds like a solid bull market, but a little digging shows a very different picture. The Invesco S&P 500 Equal Weight ETF (RSP), which eliminates the disproportionate impact of a handful of mega-caps, is down 5.75% from its peak, and if we dig even deeper and look at the iShares Russell 2000 ETF (IWM), the small-cap index is down 7.7% from its August highs.
Two Markets
We essentially have two markets. The first is the mega-cap AI-related names that are unaffected by the surge in interest rates. Even though they are spending hundreds of billions of dollars a year, they aren’t bothered by higher rates because they expect so much growth. A percentage point or two in rates doesn’t matter much when growth is running many times higher.
The second market is quite different. Interest rates are hurting valuations, and most stocks outside the AI group have anemic growth. Many of these companies are facing the most difficult economic condition of all which is stagflation. Stagflation is the combination of slow growth combined with rising costs.
The Setup
This two-tiered market action has created an odd situation as we move into the fourth quarter and earnings season. Much of the market is oversold. Stocks have struggled for a while on inflation concerns and higher rates. The drop has been so severe that many stocks have already priced in substantial bad news. Many stocks have been in a bear market for a while.
On the other hand, the AI names keep chugging along. They haven’t had much upside momentum, but they are holding steady and benefit from inflows whenever inflation worries spike again.
The big question going forward is what happens to the gap between those two groups of stocks. Can the AI names continue to produce relative strength while the rest of the market crumbles? Has the selling in the non-AI group become so severe that an oversold bounce is in the cards? Will concerns about AI capital spending be an issue in the upcoming earnings reports?
No one knows the answers to those questions, but we do know that technical conditions are unusual and extreme, and that is likely to produce higher levels of volatility.
Statistically, conditions are quite positive for the fourth quarter. In years when the S&P 500 was up 10% to 20% after nine months, as it was this year, the fourth quarter was higher 21 out of 24 times going back to 1928. We not only have traditional fourth-quarter strength, but the midterm elections also tend to be a positive market event.
Game Plan
I’m not going to try to predict what the indexes will do. Conditions are good for pockets of recovery in the non-AI stocks that have suffered the most, but I’m not as confident that the AI names can generate strong momentum as they report earnings.
My game plan for a while has been to maintain high cash levels and wait for better chart development in the stocks on my shopping list. It has been a long wait, and most charts still need more work. I’m ready to buy if the price action cooperates. The oversold technical conditions combined with seasonality look promising, but we need some better price action to confirm a change in market trend.
At the time of publication, Rev Shark had no positions in any securities mentioned.
