What’s Ailing Stocks?

The S&P 500 hasn’t had a massive swoon but is 6.6% off its end-of-July high. Let’s look at some of the proximate causes of the weakness in the stock market. While the looming U.S. government shutdown on October 1 is a convenient excuse for the market weakness, as detailed here, the disruptions from the shutdown don’t tend to rise to the level to determine the direction of stocks.

The so-called Magnificent 7 stocks, which are still up almost 84% year-to-date, have stalled a bit but are only 2% off their mid-July highs. The Magnificent 7 are still being buoyed by their relation to artificial intelligence and tech-rebound, so they are not the primary source of our woes. Magnificent 7 is comprised of Microsoft MSFT (MSFT), Apple AAPL (AAPL), NVIDIA NVDA DIA (NVDA), Tesla TSLA (TSLA), Alphabet (GOOGL), Meta Platforms FB (META), and Amazon AMZN (AMZN).

As reflected in the performance of the cyclical stocks versus consumer staples, the optimism about the ability of the U.S. economy to avoid recession was growing until around the same time as the market peak. Cyclical stocks are very economically sensitive and can be used as economic barometers. While the economy is at low risk of recession in the short term, concern has begun to build again about a downturn in the medium term.

While there are extended periods due to other variables when it is not the case, higher interest rates are generally consistent with lower valuations of any financial asset, including stocks. During Berkshire Hathaway’s BRK.B 2013 annual meeting, Warren Buffett explained the relationship, “You know it— interest rates are to asset prices, you know, sort of like gravity is to the apple. And when there are very low interest rates, there’s a very small gravitational pull on asset prices.” As yields have rebounded from the historic pandemic lows, valuations have rightly compressed.

Separating nominal interest rates from real, after-inflation rates is also essential. Looking at the 10-year U.S. Treasury yield and subtracting inflation expectations, real yields have returned to levels not seen since before the Global Financial Crisis and the meltdown in the banking system. Notably, the sharp vertical spike in these real rates began when the stock market peaked at the end of July. The meaning is two-fold. First, the recent rise in yields is not due to increased inflation worries. Second, a higher real rate is a stronger competitor to stocks because investors should prize after-inflation returns rather than nominal ones. After-inflation returns are crucial to maintaining and growing purchasing power.

While, as noted previously, inflation expectations have not yet become an issue, oil and gasoline prices have rebounded recently. The economy and consumers enjoyed the costs of both being below year-ago levels for 2023 until September.

While interest rates are crucial for asset pricing, earnings are another essential variable. Earnings growth can overcome the gravity of yields. Consider that the history of the stock market, which has produced the highest nominal and after-inflation returns of any asset class, is marked by a rise in corporate earnings. While stock prices may not follow corporate profits in the short-term, they are tied together over the long term. Consensus estimates of the S&P 500 earnings of the coming year started to decline after the market peaked in July. Recently, there has been an uptick in the profit forecasts, which could help mitigate the sharp rise in real yields.

The sharp increase in real yields is likely the primary cause of the recent stock market weakness. Higher after-inflation yields provide a more potent competitor to stocks than just higher nominal yields. The good news is that the markets expect the Federal Reserve to succeed in its battle against inflation. The crucial variable to watch will be whether earnings estimates can rise enough to offset the drag from higher interest rates.