Stock Market Vulnerability On The Rise
The stock market has been experiencing a prolonged rally, defying bearish fundamental signals and driven by various structural factors. Increased short-term liquidity, underweight positioning, dealer flows, and falling implied volatility have all supported equities since late 2022.
However, as the market continues to climb and these bullish dynamics lose steam, signs are emerging suggesting that we may be approaching a point where the harsh reality of the market’s fundamentals comes to the forefront.
In recent weeks, a growing number of bearish signals have emerged. Net liquidity has not been supportive of higher equities since April, signaling a potential downturn. Additionally, the bond market is showing troubling developments as bond yields appear to be breaking out to the upside of a bull-flag continuation pattern.
A breakout in yields could lead to a rise in interest rate volatility, which historically has been a bad outcome for equities. The Nasdaq, in particular, is vulnerable to this dynamic, with a growing divergence between itself and yields.
Investor sentiment is reaching extreme bullish levels, triggering a bearish reading on Morgan Stanley’s Market Sentiment Indicator. Short-term buy/sell signals are also being triggered, including the relative strength of stocks vs. bonds and volatility sell signals on the S&P 500 and the Nasdaq.
Furthermore, longer-dated implied volatility measures have diverged bearishly from price, indicating rising uncertainty in the near term. Changes in positioning are also noteworthy, as investors have slowly shifted from being underweight risk assets to more bullish positions.
Despite these mounting headwinds, the market could still continue to rise. Market internals, such as pro-cyclical stocks vs. the S&P 500 and investor risk appetites, indicate favorable conditions for higher prices. Short-dated implied volatility spikes, like the one seen recently ahead of the CPI release, are likely to provide short-term fuel to the markets.
When assessing the longer-term outlook for stocks, it is important to consider economic, liquidity, and financial conditions, all of which are currently unsupportive. Long-term movements in yields have historically preceded changes in stocks, and the current rate environment is unfavorable for equities. Earnings outlook and valuation metrics also pose challenges for the market.
While a minor pull-back or consolidation may be expected in the near term, it is important to remain cautious. Markets can stay irrational for longer than expected, and with passive, systematic strategies dominating recent years, the potential for extended moves is higher.
In conclusion, while the current market conditions may still support further gains, a growing number of bearish signals suggest that vulnerability is on the rise. Investors should carefully evaluate the market’s fundamentals and assess the risks before making investment decisions.
