Check Your Engines: Major Indices Come Under Pressure From Falling Yields

The “check engine” light flashed on the rally’s instrument panel this morning. That little oil can icon looks to be glowing as well.

A wave of selling hit the market overnight amid fears that falling yields could suggest economic slowing. This followed a downturn in European and Asian stocks and another leg downward in crude, which is now off more than $5 a barrel from the six-year high it posted earlier this week. 

The benchmark U.S. 10-year Treasury yield fell to 1.26% this morning, the weakest level since Feb. 18. European and Japanese bond yields fell, too. The U.S. 10-year yield has been falling steadily since topping near 1.78% in March, but things have really accelerated the last few weeks. They say bonds move first, and that’s definitely the case this time. 

A few months ago, it looked like we were on the road to 2% or higher as inflation ramped up, but now the question is whether we’ll see a 1% yield again before we get to 2%. If inflation isn’t an issue, then perhaps the economy isn’t growing as quickly now as it had been back in April and May when inflation ramped up. Higher inflation is often a sign of faster economic growth. 

If we’re entering an environment where economic growth gets questioned, that could be bearish for some of the “cyclical” sectors like Energy and Financials that helped lead the rally so far this year. Bank stocks came under pressure in pre-market trading this morning. The semiconductor sub-sector of Tech might also be more vulnerable if economic growth gets questioned. Chip stocks are sometimes referred to as Tech’s version of  “cyclicals” since they’re especially attuned to economic growth. Also, some have exposure to cryptocurrency, which is lower today. 

Meanwhile, some of the more “defensive” sectors like Staples, Health Care, and Utilities might benefit. Also, we might see more of what’s been going on the last few sessions as investors pile into “mega-cap” Tech stocks that some seem to feel could offer a port in the storm, so to speak.

Keeping Perspective

Having said that, let’s not get carried away. The market posted record highs yesterday, and last week’s jobs report was a blowout. Initial jobless claims of 373,000 today were up a bit from the Street’s average estimate of 350,000, and while it’s disappointing from a human impact standpoint to see jobless claims continue at higher levels than pre-Covid, it’s not a number that would scare the children because it’s in the same realm as most recent reports. 

Economic growth is the highest in nearly four decades. Things may be looking worrisome in the bond market, and no one should write that off. But let’s see if stocks find some “buy the dip” interest as they decline. That’s been the pattern all year. Even with the overnight losses, the S&P 500 Index (SPX) is trading basically in the same place where it started the month just a week ago. One key thing to watch is whether the SPX can hold 4300 after the futures market fell below that this morning.

The Fed minutes from their last meeting released yesterday didn’t sound too hawkish, so yields really didn’t get any new information to arrest the slide. Some analysts think we’ll have to wait until the Fed’s Jackson Hole gathering late next month for updates on any tapering of Fed stimulus, but if the June inflation numbers next week don’t get people worried, maybe the taper concerns a month or two ago will start to look overdone.

Falling Yields Could be Caution Signal For Economy

Caution continued to be a theme Wednesday even though major indices rebounded to new records. You could track some investor hesitancy in the weaker 10-year yield, the stronger dollar and gains in the so-called “mega-cap” stocks like AAPL, Amazon AMZN, MSFT, and Facebook FB that seem to be playing a defensive role. Some investors appear to gravitate toward those stocks and the U.S. dollar when it looks like harder times might be ahead. However, even the FAANGs moved lower in pre-market trading Thursday. 

Other stocks rising mid-week that could play into this cautionary tale include Procter & Gamble PG, PepsiCo PEP, and Clorox CLX, all of which also performed well back in the first days of the pandemic. 

Meanwhile, some sectors that tend to get hurt when the economy slows down are showing some bumps and bruises. Small-caps come to mind, as the Russell 2000 (RUT) index of small-caps is down about 2% in the last week. 

In some ways, Wednesday looked like a repeat of Tuesday, with banks and airlines taking it on the chin amid lower rates and worries about the Delta variant of Covid perhaps limiting overseas travel. Three of the five “FAANGs” gained ground, with Apple AAPL on the verge of its first new high since early this year. As noted yesterday, sometimes seeing strength in shares of AAPL and Microsoft MSFT makes some investors more comfortable investing in equities overall. 

Greenback On A Roll

One interesting thing is how the U.S. dollar keeps rolling up gains. The dollar index is flirting with 93 after falling to around 90 a month ago. Now, 93 isn’t historically that high considering the index traded over 100 a few years ago, but it does seem to be building strength here even as yields crumble. The dollar’s firmness could be one factor weighing on crude, which fell below $72 a barrel at times on Wednesday. 

As far as worries about the economy, what numbers should investors consider watching to see if the Treasury market has something to tell us? There are earnings starting next week, of course. They start with most of the biggest U.S. banks. Analysts look for huge year-over-year gains in overall earnings per share and revenue (see more below). Failure to hit the high estimates might be one signal of things not barreling along like they were. 

Last week’s jobs report looked very encouraging, and today’s weekly initial jobless claims could also help tell more of the economy’s story. Recent jobs numbers mostly look healthy, at least when you consider them on a post-Covid basis where many people remain unemployed due partly to structural issues in the economy caused by the pandemic.

As research firm Briefing.com pointed out, not all “growth stocks” did well yesterday despite the lower rates. Tesla TSLA, Nvidia NVDA, and FB all fell, while some cyclicals rose. You’d typically see the opposite in a falling rate environment with economic growth concerns.

We should have a much broader picture of the economy in a week after the first batch of bank earnings, consumer and producer prices for June, and retail sales. Until that’s under investors’ belts, it’s a bit of a guessing game why yields keep crumbling. Hopefully, executives at companies reporting next week including JP Morgan Chase JPM and Goldman Sachs GS can provide some clues.

CHART OF THE DAY: TREASURY YIELDS SLIDE. The 10-year Treasury yield (TNX—candlestick) hit its lowest level since February and fell below its 38.2% Fibonacci retracement level (yellow horizontal line) of 1.28% this morning. Data source: Cboe Global Markets. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.  

Earnings Season Could Bring 2009 Nostalgia: With earnings season starting in less than a week, research firm FactSet now sees an average S&P 500 earnings per share jump of 63.6% year-over-year. That would be the largest since a triple-digit gain in Q4 of 2009, which obviously had a really easy comparison to Q4 2008 when the financial crisis caused earnings to collapse. This time there’s an easy comparison, too, because of Covid. FactSet isn’t the only forecaster expecting amazing Q2 earnings growth. You also have CFRA/S&P Global projecting 60.3%. 

It would be easy to say Q2 is likely to benefit from strange conditions a year ago, but by Q3 and Q4 last year the economy was starting to recover. That makes comparisons get a bit tougher going forward, but analysts are raising their projections for full-year 2021 earnings, too. Between March 31 and June 30, analysts tracked by FactSet raised their 2021 full-year earnings estimates by 8.6%, and now see 2021 earnings growing 35.5% with revenue up 12.4%. That’s well above estimates of around 20% for EPS growth when the year started.

Valuation Calculation: What does all this mean for investors? Well, if the average analyst estimate for calendar-year earnings is correct, it means valuations could start coming down from historic highs, barring another huge rally in stocks. Although we recently hit new record highs for some of the major indices, the market’s basically been consolidating for the last few months. A strong earnings season accompanied by company guidance that’s in line with analysts’ more optimistic 2021 expectations has a chance to make stocks start to look more attractive from a valuation standpoint, possibly providing a new catalyst. 

The SPX is still highly valued on a historic basis at around 21.4 times the average estimate for earnings over the next 12 months, according to FactSet. The historic normal is more like 16. The premium valuation might be one reason there’s hesitation in the market right now, especially with major indices at or near record highs. With analysts dialing in 60% or better earnings growth for Q2, it’s going to be challenging for companies to beat those estimates by a huge amount, so what it might come down to is performance in Q3 and Q4 when comparisons get closer to normal. That’s another reason why guidance is so important this earnings season. 

EV, Work From Home Stocks Found Buyers In June: If there’s a pattern in this week’s June TD Ameritrade Investor Movement Index® (IMX), it looks like investors tracked by IMX soured a bit on health care and “work from home” stocks while jumping into stocks with exposure to cryptocurrency, China, and electric cars. Ford F has been a perpetual name among the popular stocks tracked by IMX over the last six months. What they’ve done in the EV space seems to really be resonating with some investors. In a few cases, it appears some investors used new 52-week highs—especially in the “stay at home” and Health Care areas—as an excuse to sell and look for new opportunities. We saw that last month when Eli Lilly LLY shares fell after the company got good news from regulators about its Alzheimer’s disease drug. 

The IMX is TD Ameritrade’s proprietary, behavior-based index, aggregating Main Street investor positions and activity to measure what investors actually were doing and how they were positioned in the markets.

TD Ameritrade® commentary for educational purposes only. Member SIPC.

Image by Alessandro D'Andrea from Pixabay