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Inside the Broker - Decision time for US stock indices


Inside the Broker

Decision time for US stock indices

We’re rapidly approaching the summer months where, typically, trading volumes decline as market participants leave town. That wasn’t the case last year of course, for obvious reasons. But it’s quite likely that we’ll see a drop in volumes this summer, even if traders aren’t able to make it abroad for a break. Lower trading volumes often lead to choppy markets and increased market volatility, so do be aware of this especially in the weeks leading up to the Jackson Hole Economic Symposium at the end of August. But before we get there, there’s the bulk of the second quarter earnings season to deal with.

Big Tech reports

This week sees ‘Big Tech’ report its numbers. By the time this blog is published, Tesla will have released its latest trading update. But that still leaves Apple, Alphabet, Amazon, Facebook, and Microsoft to deliver their numbers. There are two main reasons why these companies represent the core of the earnings season. For a start, they are considered ‘growth’ companies. These are the big, exciting innovators where the future is always brighter than the present. The theory is that no matter what they have already achieved, there will be even better and bigger things coming in the years ahead. That is why they flourish when interest rates are low. They can borrow now at little cost to invest in future development. That’s the theory, anyway. Contrast this with boring old companies such as Procter & Gamble or Coca-Cola? When are they ever going to innovate, or throw up a product like the iPhone? The answer is that they won’t, although being ‘value’ companies you can expect them to pay out a regular dividend, no matter what the financial environment. But who’s interested in a measly 3.5% annual dividend that won’t cover inflation when you can buy a tech stock that has the potential to rise 20% in a year, or more? Tesla rose over 700% last year, and while it’s the most egregious example, even Amazon was up 75%. It’s this type of explosive growth which has seen the tech giants top both the S&P 500 and the NASDAQ in terms of market capitalisation. This means that fund managers, pension providers and other investors must make sure that they hold these stocks in ever greater numbers to ensure their portfolios are properly weighted to comply with their investing mandates. For others, it’s the fear of missing out, or FOMO, that drives the investment decision.

Profit taking?

Last week began with a sharp sell-off to round off a pull-back that had run for some days. But by Friday’s close all those losses had been made back and we saw record closing highs for the Dow, S&P 500 and NASDAQ 100. This Monday also saw US and European stock indices give back some gains. It felt as if traders were booking profits after the three major indices broke above price milestones of 35,000, 4,400 and 15,000 respectively. There’s no doubt that there’s a little edginess around ahead of tech earnings and as we get into the summer months. Whether that leads to a more extensive round of profit-taking, new highs, or both, remains to be seen.

Image shows bright flourescent cloud computing icon against a dark background of tech imagery

Bond yields

Part of the conundrum is understanding what the bond market is up to. It’s often said that the bond market is where the smart money goes whereas the dumb money heads for equities. That’s unfair and untrue. But it is important to keep an eye on bond yields no matter what you trade. Bond prices move inversely to yields, which is the rate of interest paid to the bondholder. The trouble is deciphering what a move in yields means. One of the key bond markets is the US 10-year Treasury note. Last Monday, as equities tumbled, the yield on the 10-year fell to 1.17% - its lowest level since February this year, and a decline of 36 basis points in three weeks. Today the yield stands at 1.25%. What does that tell us? Well, ignoring yield curves which gives us information about bonds with different maturities, the yield says that investors believe that the key Fed funds interest rate will be 1.25% in ten years’ time. Bear in mind that the current Fed funds rate is below 0.25%, and that the Federal Reserve’s Federal Open Market Committee (FOMC) has just forecast that it will raise rates by 50 basis points in 2023 alone. That implies that between 2024 and 2031 (roughly) the Federal Reserve will raise rates by just another 50 basis points. At first glance this appears to be at odds with the FOMC’s latest Summary of Economic Projections which it released in June. In this it anticipates a Fed funds rate of around 2.5% over the longer term. But it’s important to note that the yield on the 10-year is just a snapshot, and the current yield could be telling us several things. Firstly, that the ongoing bounce in inflation is transitory. The last CPI reading came in at +5.4% year-on-year, well above the Federal Reserve’s 2% target. But the expectation is that it will soon fall back to 2% without the need for the Fed to raise rates. Secondly, the fall in bond yields also suggests that economic growth in the US is likely to be lower than previously expected. So, again, no reason for the Federal Reserve to raise rates. But thirdly, the speed of the decline in yields as equities were also selling off suggests that investors were buying US Treasury bonds as protection. They were moving money out of risky equity markets and pushing the funds into the relative safety of bonds.

Monthly bond purchases

But against all this there’s one other vital factor that must be considered. The Federal Reserve continues to run a bond purchase programme where it adds $120 billion in Treasuries and mortgage-backed securities to its balance sheet every month. The Fed also buys Treasuries and mortgage-backed securities to replace those already on its balance sheet that reach maturity or are redeemed. This could amount to an additional $80 billion per month to its purchases. There’s no secret about this. But the central bank’s intervention means that the bond market is skewed, and the signals that yields give out may be very misleading.

Smart News

You can keep up to date with all the latest market news, along with insights and market commentary, by opening our Smart News widget. Here you have our Financial Firehose feed, designed to capture all the best postings from social media. But you can also create your own feeds and even tailor your content to your favourite watchlists. You will find Smart News in the bottom right-hand corner of your Trade Nation live account. Not yet ready for a live account? Why not try our practice-and-learn account first?


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