After A Brief Detour Into Bear Country, The S&P 500 Appears To Be Heading Higher On Monday

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(Monday Market Open) Equity index futures are pointing to a higher open as the 10-year Treasury yield (TNX) rose 55 basis points ahead of the market open. Rising yields suggest that investors may not be as worried about safe havens on Monday and some investors may be ditching bonds to buy stocks. Additionally, multinational companies may get some relief from sellers because the U.S. Dollar Index ($DXY) has pulled back 0.84% in premarket action.  

Potential Market Movers

With a decent close on Friday, buyers may be coming back into stocks which could provide some price stability. The Cboe Market Volatility Index (VIX) has fallen back below 30 but remains higher relative to its historic levels—a reminder to investors that we aren’t out of the woods yet. The VIX at these levels suggests that the market could still rise or fall by 1%. This means stocks are still susceptible to headline risk.  

With that said, the Dow Jones Industrial Average ($DJI) may have a good start to ending its eight-week losing streak because the Dow futures rose more than 1% in premarket trading. However, there’s another busy week of earnings and economic announcements ahead including durable goods orders, FOMC meeting minutes, and the PCE price index. However, today’s calendar is relatively free of major economic or earnings reports.

Earnings season is nearing its end. As of Friday, 474 of the S&P 500 (SPX) companies have reported quarterly earnings per Refinitiv. Some 77.6% of companies have reported better-than-expected earnings, higher than the long-term average of 66% but lower than the previous four-quarter average of 83.1%. Energy companies continue to dominate the earnings picture. The Q2 earnings growth rate for the S&P 500 is 11.1% but when energy is excluded, it falls to 5%. The energy sector has an earnings growth rate of 268.8%.

Inflation continues to drive stock prices. The materials sector is second to energy in earnings growth at 46.2% as prices of raw materials remains high. Consumer discretionary is the worst-performing sector of the S&P 500, falling 28.3% as  consumer sectors are facing higher input costs that are slashing profit margins. The PCE price index, better known as the Federal Reserve’s favorite inflation measure, will be released on Friday.

European markets assisted Monday’s bullish sentiment as the Stoxx Europe 600 was up 0.78% helped by positive news from Germany. The German IFO Business Climate Index and the nation’s  Business Expectations report unexpectedly rose in May, beating forecasts. The German DAX rose 0.88% on the news.

The World Economic Forum’s annual meeting started today in Davos, Switzerland. While the meeting doesn’t normally move markets, it may be an important time for countries to reestablish relationships with shrinking risks from the pandemic making room for new ones on the geopolitical front. 

Reviewing the Market Minutes

The S&P 500 (SPX) traded briefly into bear market territory on Friday, falling as much as 2.45% during the session to extend losses from its all-time high to 20.5%. However, a late-day rally took the benchmark index off its lows to close up a slim 0.01%, narrowing its decent from its all-time high to 18.6%. The S&P 500 almost joined other major indexes like the Nasdaq Composite ($COMP) and the Russell 2000 (RUT) now well into their respective bear markets. The Dow Jones Industrial Average ($DJI) remained outside of this bear country because it was down about 15% from its high during the session.

One reason for the increased volatility on Friday was that $1.9 trillion of options’ notional value—the total value if all options were exercised—expired. Additionally, investors took to bonds during the session, pushing prices higher and yields lower. The 10-year Treasury yield (TNX) fell 68 basis points to 2.787%. The yield appears to be sitting on long-term support.

Despite falling yields, growth stocks looked like they would continue to underperform value stocks. The S&P 500 Pure Growth Index fell 3.15% while the S&P 500 Pure Value Index fell 2.36%. However, the rally trimmed the losses on the growth index to just 0.12% by the end of the session and the value index finished lower at 0.28%.

Oil futures closed barely positive at $110.05 per barrel creating that commodity’s  fourth straight week of gains. Higher oil prices helped many clean energy stocks trade higher on Friday. RBOB gasoline futures also rose 0.55%.

Despite the higher oil and gasoline prices, Tesla (NASDAQ: TSLA) fell 6.42% on the day, down more than 48% from its high. However, the entire electric vehicle group has been falling as inflation and supply chain issues are making business more difficult. Also, consumer discretionary and technology stocks have struggled as investors focus on value. 

However, Tesla was recently dropped from S&P Global’s (SPGI) S&P 500 ESG Index. The company that made electric cars cool was booted because Tesla doesn’t have a comprehensive low-carbon strategy that’s allowed other companies to move ahead of Tesla in ESG ratings. The move puts ESG scores under fire once again as such ratings have companies like Russia’s energy giant Gazprom carrying ESG labels. 

Three Things to Watch

Narrowing Exposure: Many hedge funds have been reducing their exposure to equities. According to the Financial Times, Goldman Sachs GS, Morgan Stanley MS, and JPMorgan JPM are firms that provide trading service to hedge funds. These companies have seen these funds greatly reduce their exposure to stocks. Goldman reported on May 12 that it had seen five consecutive days of declines in gross leverage—the total value of long and short positions together—among its U.S. long-short equity hedge fund clients.

Morgan Stanley also reported that gross leverage among its U.S. long-short hedge fund clients fell to its lowest level since April 2020 when hedge funds were dealing with the pandemic. While JPMorgan reported similar findings, it also said that hedge funds had more room to cut despite the market nearing a bottom.

Thousands of hedge funds in China are nearing inflection points that trigger clauses in the funds’ contracts to start selling stocks, according to Bloomberg. The clauses are meant to avoid large losses but could actually compound losses China has already experienced. China’s zero-COVID policy has caused the CSI 300 Index to fall nearly 20% from its December high.

Deleveraging and Re-leveraging: The trend of deleveraging isn’t just in hedge funds. Rising rates and market uncertainty have made trading on margin more costly, so investors are turning away.  According to FINRA, margin balances fell about $50 billion from February to April. May numbers should be released sometime today. Reduction of margin is a reduction in demand for shares.

However, investors appear to be turning to the options markets to fill their leverage needs. As mentioned above, on Friday $1.9 trillion of options notional value expired. Options contracts linked to the S&P 500 (SPX) constituted $855 billion of the volume, single stocks made up another $460 billion, and the rest was spread across other indexes, futures, and exchange traded funds (ETFs). According to Bloomberg, daily options volumes are on track for an annual record.

Trimming the Hedges: A far more terminal way of deleveraging is closing a hedge fund altogether. Melvin Capital Management LP plans to shutter its hedge funds and return the money to its investors. Melvin had experienced large losses in the last 17 months and decided to call it quits.

Several tech-focused funds like those managed by Brad Gerstner and Tiger Global have gotten crushed by declining tech and growth stocks. While there are no plans to shutter these funds, it may be difficult to keep investors when performance is bad.

However, the picture may not be so bleak for all hedge funds despite the bad news. CNBC reported that hedge funds saw their biggest inflow of cash in seven years as investors look for help navigating markets. Investors gave hedge funds $19.8 billion in the first quarter of 2022.

According to the HFR Global Hedge Fund Industry Report, hedge fund assets grew to $4 trillion in 2021 and 614 new funds were launched. Meanwhile, 527 were liquidated, which is actually the lowest number since 2004. Perhaps investors are okay with letting the hedges grow.

Notable Calendar Items

May 24: New home sales and earnings from Intuit INTU, Best Buy BBY, Ralph Lauren RL, Toll Brothers TOL, and Nordstrom JWN

May 25: Durable goods, FOMC meeting minutes and earnings from NVIDIA NVD, Splunk SPLK, Williams-Sonoma WSM, and Dick’s Sporting Goods DKS

May 26: Gross domestic product, pending home sales and earnings from Medtronic MDT, Dollar General DG, Snowflake SNOW, and Workday WDAY

May 27: PCE Price Index and earnings from Dell DELL, Domo DOMO, and Hibbett Sports HIBB

May 30: Markets closed for Memorial Day 

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

Image sourced from Unsplash

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