Stocks have rebounded from the worst downturn of the year, but there is no indication that the concerns hanging over the market have suddenly cleared.
Most of the attention is centred on the S&P 500, which hit a record intraday high on May 22 but then slumped more than 5 per cent in just 11 trading days. That’s not exactly market carnage, but it interrupts what has been a remarkably smooth ride over the past six months.
On Thursday, the index closed at 1,622.56, up 13.7 points, after falling as low as 1,598 earlier in the day and touching a one-month low.
Stock markets everywhere are looking vulnerable. Japan’s Nikkei 225 has fallen more than 17 per cent from its recent high. Blue-chip euro-zone stocks have fallen nearly 6 per cent.
Bonds, too, have been shaken. The yield on the 10-year U.S. Treasury bond has moved above 2 per cent over the past two weeks, up about half a percentage point, as prices have fallen.
Bill Gross, managing director of Pacific Investment Management Co., or Pimco, home to the world’s largest bond fund, has declared that the three-decades-old bull market in bonds is over.
Okay, he said the same thing in 2010 . But if he’s right this time, investors will be living in interesting times: Very low bond yields in recent years have made stocks look attractive by comparison.
The market turbulence follows what had been rising confidence among many key strategists. In May, Goldman Sachs raised its year-end target on the S&P 500 to 1,750 and argued that the good times would persist through 2015. JPMorgan raised its target by 135 points, to 1,715.
“With the benefit of hindsight, this group hug might have been a contrary indicator,” said Ed Yardeni of Yardeni Research. “To proceed higher, the bull market may need fewer bulls.”
He thinks that is likely. Certainly, small investors have been scared off. The latest sentiment survey from the American Association of Individual Investors showed that those with a bullish disposition have fallen to just 29.5 per cent, down from 49 per cent just two weeks ago.
According to Bespoke Investment Group, that marks the survey’s sharpest two-week decline during the entire bull market, which began in 2009.
Most observers agree on the source of the concern: the U.S. Federal Reserve’s commitment to its bond-buying stimulus program, known as quantitative easing.
The Fed has been buying bonds at a clip of $85-billion (U.S.) a month. However, some Fed officials have argued that the pace should be tapered this year – and improving employment statistics and economic growth are giving their arguments some heft.
“The May shakeout, caused by concerns of tapering and the 50-basis-point backup in U.S. and Japanese 10-year yields, was to us an unambiguous shot across the bows for liquidity addicts,” said Michael Hartnett, chief investment strategist at Bank of America, in a note.
“After all, historic levels of monetary stimulus and government intervention in financial markets have, in our view, been the primary cause of the Wall Street boom.”
Even though the bull market has sent the S&P 500 up nearly 140 per cent from its financial crisis lows, without a correction of more than 10 per cent in nearly two years, market watchers remain hopeful that the current stock-market turbulence will blow over even if bond yields march higher.
Avery Shenfeld, chief economist at CIBC World Markets, pointed out that the five significant Treasury bond selloffs of the past 25 years were followed by U.S. stocks rising by an average of 9 per cent over six months.
That’s not a fluke. If rising bond yields are associated with an improving economy, then rising corporate earnings and dividends are likely to follow.
This helps explain why economically sensitive stocks have been leading the S&P 500 since the start of May. Financials, tech stocks and consumer discretionary stocks have outperformed defensive sectors like utilities and staples. This outperformance has persisted during the downturn, too, making offence look like the best defence.
“We can’t deny that the mood in the market is to push equities lower on days when bond yields spike higher,” Mr. Shenfeld said in a note. “But we would buy into any meaningful correction prompted by Fed fears, expecting that the bond market’s bark will be worse than its bite.”
Mr. Hartnett agrees: “Our core conviction remains that higher rates in coming years will be bullish for stocks and bearish for bonds.”
But the current turbulence has the bulls watching their backs, with Mr. Hartnett warning that the transition to higher bond yields could be messy. In fact, he is not ruling out a repeat of the 1987 crash, which saw the Dow Jones industrial average sink 22 per cent in a single day.
Let’s call that forecast bullish, with a chance of disaster.