Fast-reversing Markets Humble Wall Street

As inflation surges, economic growth decelerates, and the two-year Treasury yields hit 5%, Bill Gross discerned a waning melody in the markets and advocated moving beyond the allure of the tech giants.

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In a Thursday morning post on X (formerly Twitter), the co-founder of Pacific Investment Management Company advised investors to focus on value stocks while steering clear of the tech sector, for the time being. However, just a day later, the tech-heavy Nasdaq Composite Index experienced its most robust session since February, driven by strong earnings reports from Microsoft Corp. and Alphabet Inc., demonstrating that the AI-driven earnings boom still holds strength.

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This recent turn of events presents another moment of reflection for those attempting to grasp the short-term fluctuations of the markets, especially as uncertainties emerge regarding the feasibility of an economic soft landing. An exchange-traded fund (ETF) riding the momentum trade surged by 3.5% this week after plummeting 5.6% the previous week.

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Macro indicators continue to confound analysts. While growth slowed more than anticipated according to a report released Thursday, indicators of consumption and investment remain positive. Strong personal spending data the following day was greeted enthusiastically by economic optimists but raised concerns among inflation watchers.

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Despite these mixed signals, money managers propelled the S&P 500 more than 2.5% higher for the week, demonstrating a willingness to pay a premium for companies expected to generate profits in the coming years.

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“Tech/growth stocks used to be impacted by higher yields,” Gross stated in an email to Bloomberg on Friday. “But not at the moment.”

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Given the heightened volatility in stocks and Treasuries, money managers who share Gross's caution have been rushing to hedge their investments in richly valued equities through exchange-traded funds. Meta Platforms Inc. and International Business Machines Corp., for instance, collectively lost $150 billion in market value on Thursday alone.

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However, despite the reassessment of the Federal Reserve's mid-year monetary strategy, which has pushed yields higher, risky assets have remained surprisingly stable. Recent market fluctuations, coupled with mixed economic data, are humbling lessons for many on Wall Street. Thursday's GDP report, which revealed growth of a mere 1.6% and core inflation at 3.7%, defied the predictions of Bloomberg surveys.

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“The recent series of higher-than-expected inflation data is disrupting most people's models. Identifying market inflection points is always challenging,” noted Chris Zaccarelli, chief investment officer at Independent Advisor Alliance. “It's difficult to remain humble and acknowledge uncertainty about the future direction, so we must emphasize the importance of diversification and hedging against tail risks.”

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After sliding 5.4% the previous week, the Nasdaq 100 rebounded by 4%, including a 3.3% surge in its seven most dominant stocks on Friday alone. Investors who had been withdrawing from equities and high-yield bonds found themselves reinvesting this week, as reported by Bank of America, citing EPFR Global.

Resilience characterized every market during the week, except for Treasuries, where yields remained at multi-month highs. Interest coverage ratios have improved for both investment-grade and high-yield bonds amid robust earnings and persistent expectations of monetary easing, according to Torsten Slok, chief economist at Apollo Global Management. This rise in the ratio between companies’ earnings and their interest expense suggests they have more income to service their debts.

For William Hobbs, head of UK multi-asset wealth at Barclays Wealth Management, this presented an opportunity to buy during the dip and adjust the broader portfolio in favor of risk.

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“Despite the strong performance of many developed stock markets so far this year, our proprietary measures of investor sentiment and positioning do not indicate imminent red flags,” Hobbs remarked.

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Nonetheless, signs of apprehension emerged during a week of uneven earnings results, with losses in Meta and IBM more than offset by weekly gains of 12% in Google parent Alphabet and a 14% surge in Tesla Inc. The Cboe NDX Volatility Index, which measures option costs tied to the Nasdaq 100, hovered around 20 after reaching its highest level since October the previous week.

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Consensus forecasts still project all-time high net margins for the tech sector by the end of 2024, according to Bloomberg Intelligence. This, among other factors, explains why risk assets have continued to resist threats from rising bond yields, even as their valuations and expected cash flows are influenced by changes in interest rates. Consequently, this week saw growth stocks outperform value stocks.

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Yet, this dynamic threatens to ignite new tensions between stocks and bonds, particularly with Federal Reserve officials convening next week against the backdrop of a surging Wall Street and persistent inflationary pressures.

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“Tighter financial conditions are warranted to temper the overheating US economy,” stated Tiffany Wilding, economist at Pimco. “Based on recent remarks, the Fed seems poised to respond by maintaining its current stance for longer. In essence, the pivot party is over.”

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