The U.S. bond market has been sounding an alarm over the direction of the economy for weeks, and some investors are wondering whether stocks will follow suit as markets approach a late summer period that has historically been marked by volatility.
The benchmark S&P 500 index was down around 2% on Monday, with cyclical sectors such as energy stocks falling nearly 4.5%. At the same time, a flight to safety in the wake of growing expectations that the U.S. economic rebound will slow in the second half pushed 10-year Treasury yields, which move inversely to prices, to a five-month low of 1.18%.
Stocks are still near their record highs, and investors have been well-rewarded for buying dips during the S&P 500′s roughly 90% climb from its March 2020 lows. Still, some believe that worries over the spread of the COVID-19 Delta variant could give investors an excuse to take profits and spark a pullback.
“The market has shown time and again that when things get really bad from a COVID standpoint, it really starts to struggle,” said Sameer Samana, senior global market strategist at Wells Fargo Investment Institute, noting stocks could be due for a 10% decline known as a correction.
Although equities had appeared placid in the face of the recent drop in yields, investors have noted rumblings under the surface. Among them has been the market’s narrowing breadth, with a handful of big growth names leading indexes higher while the typical stock languishes, which is a worrying sign, according to Morgan Stanley’s Michael Wilson, who said such scenarios usually end with a 10% to 20% correction.
In a note published on Monday, Wilson said market breadth is “the weakest we have ever witnessed,” with more S&P 500 stocks having hit 52-week lows than 52-week highs over the last month.
“We think it is foreshadowing a significant growth deceleration in earnings and the economy that may feel worse than most are expecting,” he wrote.
At the same time, stocks are primed to enter a late-summer period that has historically been marked by comparatively weaker performance. Since 1945, September has put up the worst monthly performance for the S&P 500, falling 0.56% on average, while August’s average flat performance has been the third-worst month, according to Sam Stovall, chief investment strategist at CFRA.
Some corners of the options market indicate investors are growing much more fearful of a sharp pullback than they have been in months, with demand for hedges against a big market drop rising sharply in recent weeks.
“Don’t forget that the S&P 500 hasn’t had a 5% correction since October, so you could say we are more than due for some turbulence,” Ryan Detrick, chief market strategist for LPL Financial, wrote on Monday.
Still, some investors see the sell-off as a chance to add to positions after the recent market run-up that has the S&P 500 up about 13% for the year to date.
“Fear is ruling the day despite strong economic activity,” said Bryce Doty, senior portfolio manager at Sit Fixed Income Associates, in a note to investors. “We do not expect a return to complete shut-downs in the U.S., so while the damage from the Delta variant can be significant, we are still in the ‘buy the dip’ camp.”
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