The Dawn for Stock-Market Bulls

It seems that the stock-market bulls may face some darker times before they can see the light of dawn.

The S&P 500 index (SPX) experienced a 7% pullback from its July 31 high, which might not be unusual, but what has accompanied it is quite remarkable. The Treasury market has witnessed a rout that has propelled yields on 10-year notes (BX:TMUBMUSD10Y) and 30-year bonds (BX:TMUBMUSD30Y) to levels not seen in 16 years.

As a result of this stock market slump, investor sentiment towards equities has turned increasingly pessimistic. Interestingly, extreme pessimism among investors often acts as a contrarian indicator, historically preceding strong stock market gains. In fact, strategists Ed Clissold and London Stockton of Ned Davis Research have noted that since 1994, the S&P 500 has risen at an impressive annual rate of 26.7% when their Daily Trading Sentiment Composite has been in its extreme pessimism zone.

However, things are not that straightforward due to the ongoing Treasury market rout. The decline in bond prices has led to even greater pessimism towards fixed income among investors, according to NDR’s proprietary indicators. In fact, Treasury bond futures (TY00, +0.15%) have dropped by approximately 17.5% since their peak on April 6.

Furthermore, the NDR Daily Bond Sentiment Composite is currently at its lowest level since March and firmly in its extreme pessimism zone. Surprisingly, even with such negative sentiment, T-bond futures have managed to achieve an annualized gain of 4.8%.

The simultaneous decline of both stocks and bonds is quite rare, although investors still remember the devastating 2022 rout that severely impacted traditional portfolios split between the two asset classes.

So, what is causing this situation? According to Clissold, inflation is to blame. For the majority of the past 25 years, stocks and bond prices usually moved in opposite directions. However, in recent times, stocks have tended to rise alongside rising Treasury yields.

It remains to be seen how this complex relationship between stocks and bonds will play out and whether the stock market bulls can weather this storm. The interplay of market forces and investor sentiment will undoubtedly be intriguing to watch in the coming days.

Rising Yields and the Stock Market: A New Perspective

Before the early 1990s, an increase in bond yields usually coincided with a decline in stock prices. This relationship signaled to investors that the Federal Reserve would need to intervene to combat inflation. However, analysts now argue that the correlation has changed.

Historically, rising long-term yields were interpreted as a bullish sign for stocks, reflecting a decrease in deflationary pressures. David Clissold and Scott Stockton noted that when investors exhibit more pessimism towards bonds compared to stocks, bonds tend to outperform.

This observation leads to two potential scenarios. In one scenario, if anxiety surrounding both stocks and bonds intensifies, we could experience a “risk-off” environment. Treasury bonds would rally while stocks continue to correct. This capitulation could potentially trigger a year-end rally in the stock market.

However, Clissold clarifies that the current stock market selloff does not qualify as a panic-induced capitulation event. It is rather a typical and broad-based decline. The Cboe Volatility Index (VIX) has risen, but it has not reached extreme levels. Moreover, the S&P 500 has not suffered significant outsize down days.

If investors were to adopt a “completely risk-off” attitude, Treasury bonds would rally due to increased safe-haven demand. This would lead to a decrease in yields and alleviate the sentiment gap between equities and bonds. Additionally, the stock market would reach deeply oversold conditions that often precede a rally.

Barclays analysts argue that a more pronounced stock-market selloff is necessary to reverse the tide in the bond market. Nevertheless, another plausible outcome is that both stocks and bonds could rally simultaneously, with bonds outperforming.

In conclusion, the market will ultimately dictate the outcome of this dynamic relationship between rising yields and the stock market.