Equity rally wobbles as risk-on sentiment eases

The seemingly unstoppable stock market rally is wobbling as it confronts a horde of challenges to the momentum that’s taken it from record high to record high.

A rout early last month was a glimpse of how quickly things can turn bad, a sharp selloff driven by US recession fears that rocked investors used to going in only one direction. While the S&P 500 subsequently rebounded, crucially it didn’t made back all the ground lost. 

Then, US data Friday showing weaker payrolls growth reinforced the view that the labor market is cooling and sent stocks reeling. The S&P 500 fell 4.25% last week, while the Nasdaq 100 lost the most since November 2022. 

Worries about the US are just one of the cracks. There’s also concern about growth in China and Germany, and the implications of that weakness on earnings and prices. That’s making the way forward look more volatile, even as the foggy rate path clears up and investors count down the days to the first Federal Reserve interest-rate cut in four years.

Then there’s the US election, turbulence in European politics and the concentration of money in mega-cap tech stocks, all risks that could hurt the bullish sentiment that at times has looked utterly unshakable.

Frothy valuations have also created new vulnerabilities. Many had to chase the rally and bought at expensive levels, meaning they may sell quickly if things start to reverse, and the market could fall harder and deeper before the usual dip buying kicks in. Additionally, the shift in options trading and the forces of systematic investors are capable of triggering erratic moves and potential avalanches of de-risking.

“It wasn’t too long ago that markets were one directional and everyone piling into the same set of stocks,” said Arun Sai, senior multi-asset strategist at Pictet Asset Management. “That’s no longer the case and stocks are unlikely to repeat this relentless rally.”

NEW TARGETS

Even after the August hiccup, the S&P 500 is still up 13% this year, and the MSCI World Index has risen 10%.

A strong start to the year left strategists at UBS Group AG, RBC Capital Markets LLC and elsewhere scrambling to revise year-end targets made just a few weeks earlier. 

But the view now appears to be that the best days may have passed. The average of 20 strategists tracked by Bloomberg implies gains of only 1% more for the S&P until the end of 2024.

Of course, the market has been here before. Multiple shocks in recent years have taken a swipe at the equity juggernaut.

But whether it was the collapse of banks in the US and Switzerland, or geopolitical tensions such as the escalation of violence in the Middle East, the market reaction proved to be temporary. Equities quickly bounced back and powered on to new highs.

The biggest setback was 2022, an $18 trillion global selloff sparked by inflation and the Fed’s actions to turn off the monetary spigot. But as price pressures cooled, investors bet that the central bank would ease again. That optimism carried the S&P 500 to a 2023 recovery and then multiple records this year — 38 and counting.

TECH CONCENTRATION

If there’s one stock that sums up this year’s rally, it’s Nvidia Corp. A symbol of the concentration of cash in US big tech, it’s more than doubled in 2024. But the high dependency and clustered positioning, which leans heavily on artificial intelligence being a productivity game changer, is worrying.

Nvidia has been the single biggest driver of global equities this year, contributing nearly a fifth of the Bloomberg World Index’s 10% advance. And it’s become something of a bellwether of broader sentiment. A rout in the stock early last week also spread to risk assets, signifying just how high the stakes are if it disappoints.

“Everybody loves tech stocks because they generate quite a bit of free cash flow, but they forget about the second part of that equation, which is how much are you paying for that,” said Brent Schutte, chief investment officer at Northwestern Mutual Wealth Management. “AI is real. I think those companies are probably good companies, but are they good stocks? That’s what we’re going to find out.”

Other risks from investor positioning arise from approaches such as so-called trend followers or volatility controlled funds as well as the options market, increasingly dominated but very short-term trading. Trading flows from those investors can reinforce intraday swings, seen recently during the early August slump.

Since August, economic growth has taken center stage, with investors fearing that the US is heading into trouble and the central bank may have waited too long to cut.

On Friday, traders reacted to the payrolls data by increasing bets on a 50 basis-point Fed cut this month. But a reduction doesn’t guarantee that stocks will rally again given that any easing will be a response to slowing activity. If it’s accompanied by a more downbeat economic assessment, that could be a catalyst for further selling.

In Europe, the fretting is focused on Germany, even more so after news that carmaker Volkswagen AG may shut plants there, adding to questions about the future of its industry. It’s also facing increased political uncertainty ahead of national elections next year.

Meanwhile, demand weakness in China — a key market for makers of luxury goods, cars and machinery – is hitting earnings.

The world’s second-biggest economy has struggled with a weak post-Covid recovery, and a prolonged property downturn has crimped consumer spending. In a sign of growing pessimism, JPMorgan Chase & Co. this month dropped its buy recommendation for Chinese stocks, citing risks around the US presidential election and the threat of new tariffs.

Polls show a tight race between candidates Kamala Harris and Donald Trump. Last week, the latter made an appeal to business with a pledge to cut corporate taxes to 15%, a move that Goldman Sachs Group Inc. strategists estimate would raise S&P 500 earnings by about 4%. Harris, in contrast, has proposed raising the corporate rate as well as capital gains levies on high earners. 

“The possibility that the result of the US elections could be contested is adding a layer of uncertainty,” said Frederique Carrier, head of investment strategy at RBC Wealth Management. “I expect market sentiment to be more fragile into the year end, and stick with our preference for high quality companies.”

Active managers such as hedge funds could keep selling US stocks ahead of the Nov. 5 vote. Typically, they sell ahead of such events to have more cash ready for any volatility or big swings. 

But this time, despite a few months of consistent offloading, their exposure is elevated compared with the last six election cycles, Goldman Sachs data show. That indicates there’s more room to unwind positions.

“The biggest risk to US markets is that the economy is shifting from an expansion – which it has been in since April 2020 – into deceleration or possibly a recession,” said Jens Foehrenbach, head of Public Markets within Discretionary at Man Group. “Valuations are somewhat inflated and don’t incorporate a hard landing. Therefore, any negative surprise can trigger an outsized market reaction.”