Investors Face a Hidden Bear Market as We Head Into Earnings Season

As we start a busy week, we face an unusual situation. The S&P 500 is near an all-time high, but more than half of the stocks in the Russell 3000 are down at least 20% from recent highs. We have a de facto bear market for most of the market, but the indexes are hiding it. The big question is how this gap will resolve itself as we move into earnings season and the fourth quarter.

There is some early softness Monday morning. Oil is higher after another attack on an airport in Saudi Arabia, and Treasury futures are slightly lower after bonds bounced Thursday and Friday. It is Columbus Day, so the stock market is open, but the cash bond market is closed.

The Middle East remains a mess. A missile strike on Riyadh’s main airport on Saturday killed at least 12 people, and the airport was hit again over the weekend. The Wall Street Journal reports that Iran-backed militants are tightening the screws on Crown Prince Mohammed bin Salman, who is caught with an economy weakened by heavy spending and a miscalculation of the Houthi threat.

President Trump’s promise not to attack Iran before the midterms helped to ease oil last week, but it doesn’t stop Iran’s proxies from attacking its neighbors, and that is going to keep a floor under energy prices.

How the Gap Could Close

Equity volatility increased last week, and there were signs of rotation into lagging small-caps and secondary stocks. The iShares Russell 2000 ETF (IWM) is holding around its 200-day simple moving average, while the Roundhill Magnificent Seven ETF (MAGS) is still hitting new all-time highs, even after last week’s scare over OpenAI’s revenue.

The mega-cap AI names don’t report for a couple of weeks, but the questions are already lining up. Will their reports produce sell-the-news action? Will concerns about capital spending rise?

We already saw worries last week about OpenAI’s revenue growth, and the market’s reaction showed how quickly money can move when the AI story is questioned. It doesn’t take a collapse in the leaders to close the gap, only enough doubt to slow the money flowing into them.

What the Banks Can Tell Us

The big banks kick things off Tuesday, and they matter more than usual this time. Higher rates should help them earn more on their loans, but higher rates also squeeze their borrowers and slow loan demand.

Last week the WSJ reported that commercial real estate buyers are walking away from deals unless they get better terms. I want to hear what the banks say about loan demand, credit quality and how consumers are holding up with diesel at record prices and consumer sentiment at its lowest since May.

The financials have already started to act better. The Financial Select Sector SPDR Fund (XLF) bounced last week after touching its 200-day moving average.

If the banks deliver and the group keeps building on that bounce, it would be one of the first signs that money is willing to move into something other than AI. A positive reaction to the banks this week would be the best thing that could happen right now.

CPI Is the Other Big Test

The September consumer price index on Wednesday will be a major test as well. Fed Governor Christopher Waller made it clear last week that the Fed isn’t done raising rates, and a hot number would put the next hike back on the table quickly. That is the scenario that would hurt the secondary stocks the most, because rates have been the main source of pressure on smaller stocks.

A cooler number would do the opposite. It would give bonds more room to bounce, and as we saw on Thursday, small-caps tend to move right along with them.

Game Plan

I’m continuing to monitor charts and price action closely. Smaller stocks still have several weeks before they report, and I’ll be watching for the better ones to start attracting interest ahead of their reports. If the banks and CPI cooperate, those are the names that can lead as the gap starts to close.

Position: None