Some market gurus are beginning to worry that Wall Street’s summer rally may be faltering after stocks quickly swung from oversold to overbought.
Gene Goldman, Cetera Financial Group’s chief investment officer, explained that even though the economy is in better shape than many Americans realize, stocks are likely headed for a retreat.
“There was a lot of great news, but the market needs a little break. We’ve been going a little too fast, too fast right now,” Goldman said in a call to MarketWatch.
To support this view, he pointed to a handful of reasons why stocks’ slide could continue into Friday into next week and possibly beyond — while he remains bullish on stocks over a longer time horizon.
Defensive sectors trending again
Cyclical sectors outperformed as stocks rallied in July and early August. But that trend seemed to end this week as defensive sectors regained the lead.
“One sign investors are getting nervous is cyclicals underperforming defensive sectors, and we’re starting to see that now,” Goldman said.
Among the 11 sectors of the S&P 500 last week, two top performers were consumer staples stocks and utilities. As a result, Consumer Staples Select Sector SPDR Fund XLP, -0.32%, an exchange traded fund that tracks the sector, rose 1.9%, while Utilities Select Sector SPDR Fund XLU, -0.05% rose 1.3% % increased.
On the other hand, the two worst performing sectors were Materials and Communication Services, two cyclical sectors. Materials Select Sector SPDR fund XLB, -1.84% is down 2.4% on the week, while Communications Services Select Sector SPDR fund XLC, -1.62% is down 3.1%.
Bond yields are rising
Rising bond yields are another sign the stock rally may be about to reverse, Goldman said.
Higher Treasury yields can pose a problem for stocks, making bonds a more attractive investment relative to them. Stocks and bonds often moved in unison early in the year as expectations of tighter Federal Reserve policy shook both assets.
But that dynamic appears to have shifted in August. Treasury yields turned higher earlier this month and started rising before stocks faced a rough patch later this week.
The yield on the 10-year TMUBMUSD10Y Treasury note, 2.973%, is up 35 basis points since Aug. 1 and 14 basis points since Monday, to 2.897%.
Bond yields rise when prices fall, and Goldman and others on Wall Street are now waiting to see if stocks will follow lower bond prices.
See: The Fed’s Bullard says he’s leaning towards supporting a 0.75 percentage point hike in September
Such is the dollar
Rising Treasury yields and declining inflation have helped push the US dollar higher, creating further potential headwinds for equities. The ICE US Dollar Index DXY, +0.58%, a measure of the dollar’s strength against a basket of rivals, surpassed 108 on Friday, hitting its strongest level in a month.
See: The US dollar is burning, cutting through key technical levels ‘like a hot knife in butter’
A strong dollar is generally associated with weaker stocks because it eats away at American multinationals’ overseas earnings by making them worth less in US dollars.
Cryptocurrencies like Bitcoin BTCUSD, -0.03% and Ethereum ETHUSD, -3.12% have also been trading almost in lockstep with stocks lately, particularly megacap tech stocks like Meta Platforms Inc. META, -3.84% and Netflix Inc. NFLX, -1.64%. But crypto sold off heavily on Friday, leading some to wonder if stocks could be next.
“Another sign of a market pause is crypto weakness. This is a clear sign of a risk aversion trend in the market,” Goldman said.
Bitcoin fell about 9.5% on Friday, while Ethereum, the second most popular cryptocurrency, lost about 10%, according to CoinDesk.
Stock valuations do not align with corporate earnings
Another reason to question the stock rally is that there appears to be a disconnect between stock valuations and corporate earnings expectations.
As Goldman pointed out, the S&P 500 price-to-earnings multiple has recovered to 18.6 times expected earnings from a low of 15.5 in mid-June. At the same time, corporate earnings expectations for the same companies have fallen from $238 to $230 over the next 12 months.
“Stocks are rising on falling earnings estimates,” Goldman said.
Goldman is hardly the only one worried about rising stock valuations. In a recent note to clients of the bank, Scott Chronert, Citigroup’s US equity strategist, said the risk of corporate earnings falling into 2023 could create “valuation headwinds” for stocks.
“We would say that a tactical sell into further strength is warranted,” he said.
U.S. stocks tumbled on Friday, with the S&P 500 SPX, -1.29%, down 55.26 points or 1.3% to 4,228.48, while the Nasdaq Composite COMP, -2.01%, 260 .13 points or 2% to 12,705.22. The Dow Jones Industrial Average DJIA, -0.86%, fell 292.30 points, or 0.9%, to 33,706.74.
Friday’s stock losses drove all three major benchmarks lower for the week, marking the first weekly decline for the S&P 500 and Nasdaq in a month.
The highlights of next week’s economic data calendar are expected to arrive on Friday, when Federal Reserve Chair Jerome Powell is set to deliver his annual speech at the central bank’s economic symposium in Jackson Hole, Wyo. Economists expect he will take the opportunity to emphasize the Fed’s commitment to fighting inflation.
See: Powell to say to Jackson Hole that the recession will not stop the Fed’s fight against high inflation
In addition to Powell’s hearings, investors will get an update on the pace of inflation via the Personal Consumption Spending Index, the Fed’s preferred measure of price pressure. The closely-watched University of Michigan sentiment survey, which includes data on consumer inflation expectations, is also scheduled for Friday.