The Big Picture
Last Updated: 03-Nov-23 15:37 ET | Archive
Stuck in no man's land
The stock market is in no man's land, otherwise known as being stuck in the middle. We don't mean that it is trading just about in the middle of the 4,200-4,600 range, although it is convenient from this perspective that the S&P 500 happens to be there.
No, what we mean is that the stock market is pricing in a solution that might not be the solution it thinks it is.
Moving Quickly
If there is one thing this stock market has come to love, it is low interest rates. The main reason it has been acting poorly for the better part of the last three months is that interest rates have been rising -- quickly.
They stopped rising this past week, however, and they came down -- quickly. As of this writing, the yield on the 10-year note is down 32 basis points for the week to 4.50%. Recall that the 10-yr note yield peeked its head above 5.00% only a few weeks ago.
What happened to catalyze the reversal? Here are some prevailing explanations:
- Hedge fund manager Bill Ackman said on October 23 that he covered his short in bonds because "There is too much risk in the world to remain short bonds at current long-term rates."
- The 10-yr note yield ran into resistance at 5.00%, prompting some profit-taking interest.
- The Bank of Japan's tweak to its yield curve control policy was not as hawkish as feared, tempering concerns about the possibility of a destabilizing unwinding of carry trades.
- The Treasury reduced its Q4 borrowing estimate by $76 billion to $776 billion.
- The Treasury said its Q4 refunding would involve larger issuance and auction sizes for 2-, 3-, 5-, and 7-yr maturities than 10-, 20-, and 30-yr maturities.
- The October ISM Manufacturing Index showed activity contracting at a faster pace in October, sliding to 46.7% from 49.0% in September. The dividing line between expansion and contraction is 50.0%.
- Fed Chair Powell did not sound as hawkish as feared at his FOMC press conference, noting that the Fed has come very far with its rate-hike cycle and that policy decisions have gotten more two-sided.
- Q3 unit labor costs declined 0.8% on the back of the strongest productivity increase (4.7%) since the third quarter of 2020.
- The October employment report checked all the right rate-relief boxes, showing a slowdown in hiring, an uptick in the unemployment rate, and a slowdown in wage growth.
- Short sellers covered their positions.
Not to sound trite, but it was an outstanding week for the Treasury market, as well as the stock market. In fact, it was the best week of the year!
Perfect Timing
The timing is perfect for stocks, too. Since 1950, November has been the best month for the S&P 500 with an average return of 1.7%, according to the Stock Trader's Almanac. It also starts what has been identified as the best six months of returns (November-April) for the stock market.
So, there was a powerful combination of falling interest rates and seasonality at work this past week. The former is factual. The latter is speculative in the sense that money got put to work partly on an historical record that spurred a fear of missing out on a potential year-end rally -- a fear that increased because of the drop in interest rates.
We can only wonder now, but we wonder if that would have been the case if rates had not come down like they did. We think not, but all the wondering at this point is irrelevant. Rates fell and stocks rallied. Period.
The October employment report provided an exclamation point to the Treasury rally this week. It was the perfect report at this point in time, providing some rate-hike relief with slower payrolls growth, an uptick in the unemployment rate, and lower wage growth.
It was a "Goldilocks" report: not too hot and not too cold. It was just right to connote some slowing in the labor market and a moderation in wage inflation, which is exactly what the Fed wants to see. Moreover, it had the markings of an economy landing softly from the rate hikes, which is exactly what everyone wants to see.
In brief, it excited the stock market because it brought additional rate relief to the Treasury market and it didn't cast any strong aspersions on the earnings outlook.
What It All Means
If there is to be a stock market rally with some legs into year end, that dual relationship will need to persist. That doesn't mean rates have to keep moving lower at the rate they have been moving. It would be enough if they simply didn't return to an upward-trending formation, grounded in the thought that the Fed is done raising rates and hasn't made a policy mistake.
It is the last qualifier there that will take more time to understand. How will we know if the Fed made a mistake by tightening too much? The data will tell us all.
If the data follow a smooth glide path like the "less good" October employment report, then the stock market can live with that.
Conversely, if the data take a more sinister turn in unison, evolving from "less good" economic news into outright bad news, then it will be a more challenging story for stocks. The bad data will inevitably lead to the conclusion that 2024 earnings estimates, which call for 12% year-over-year growth, are too good and at risk of a material downward revision.
We are not at that point. The labor market data, including the leading indicator of initial jobless claims, still looks relatively good.
There are some worrisome signs, though, like the ISM Manufacturing Index, mortgage applications at a 28-year low, crude oil futures sliding after the outbreak of the Israel-Hamas War, a widening in high-yield spreads, global shipping giant Maersk cutting more than 10,000 jobs as it deals with subdued demand, and Target CEO Brian Cornell telling CNBC that shoppers are buying less, including in food and beverage categories.
Still, the totality of economic evidence remains on the soft-landing side, and that's where it needs to stay. If it goes to the other side -- the hard-landing side -- earnings estimates are going along with it. They won't be alone as a concerning factor for the stock market either.
If the economy takes a turn for the worse, tax receipts will, too, which means the Treasury will likely find itself needing to issue more debt down the road than it currently thinks. That thought will be a thorn in the side of the Treasury market, which may not provide as much rate relief as one might think in the wake of bad economic news.
So, the solution for the stock market correction this week, which proved to be a drop in market rates for a variety of reasons, won't be a solution initially if the economy shows signs of sinking -- quickly. Sure, it could bring lower rates, but it won't be for the best of reasons.
It is all well and good right now to cheer less good economic news, but a steady stream of bad economic news will spoil any rally effort if it turns into a flood of downward earnings revisions. That may not happen in the end, but it is a risk to take into account that would leave the stock market in no man's land waiting on a perceived rate-cut solution.
-- Patrick J. O'Hare, Briefing.com
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