Explaining the relative calm of the stock market as the Fed hikes rates into a mini-financial panic

Published Sat, Mar 25 20238:54 AM EDT

It might feel more eerie than soothing, but the relative calm in the stock market is hard to ignore and impossible to deny. The past few weeks have featured sudden bank failures and rushed rescues stoking investor fear, Treasury-market volatility surging to rarely seen extremes and Federal Reserve and Treasury officials forced to offer assurances about the soundness of the system. The plunge in short-term bond yields has dropped the 2-year Treasury more than a full percentage point below the overnight rate that was just bumped up a quarter-point by the Fed last week – a setup only seen a handful of times in 40 years, always near some sort of financial seizure and right before the Fed eased, according to Warren Pies of 3Fourteen Research. And yet the S & P 500 was up 1.4% last week, is about flat for March, is near where it traded before Silicon Valley Bank buckled, is up 3.4% less than a quarter of the way through 2023, has gained 13% from the October bear-market low and sits just above the mid-point of its 10-month sideways trading range. The CBOE S & P 500 Volatility Index , under 22, is far closer to its 14-month low under 18 reached Feb. 1 than to the recent SVB-panic high near 30 two weeks ago. .SPX 1Y mountain S & P 500, 1-year So, are equities under-reacting to a badly contorted bond market, a potentially trapped Fed and faltering economy? Are they looking ahead to better conditions to come? Or is the recent action at the index level mere noise masking tumult underneath? Microsoft to the rescue The most direct, mechanical answer is simply that the largest growth stocks, the Nasdaq glamor leaders of 2020 and 2021, insulated the tape from more severe damage. The Vanguard Mega-Cap Growth ETF – full of cash-generating, stable companies — is up almost 6% since the start of SVB's downfall on March 8, with the banks as a group off nearly 20%, Russell 2000 down 5% and the equal-weighted S & P 500 lower by more than 3%. This has allowed the S & P 500 excluding financials and real estate to outperform the headline index by a couple percentage points year to date. Microsoft alone has added some $240 billion in market value since that date, more than the entire market cap of the S & P 500 regional-banks sub sector. It all makes intuitive sense: Growth is seen growing more scarce so reliable growth companies regain a premium; many already saw severe cutting of profit forecasts last year; they will never need to borrow into a credit contraction. Indeed, Goldman Sachs shows how large, public non-financial companies have locked in low debt costs, which will only slowly reprice higher, having taken advantage of the generous capital markets during the years of rock-bottom rates. Yet the market doesn't always readily reward those hiding in the biggest and most obvious stocks, so this sort of rotation to safety can go only so far and long. Jonathan Krinsky, technical analyst at BTIG, noted that semiconductor stocks last week were the most over-extended relative to regional banks they've ever been. There's a world in which the rotation reverses in a tidy way as oversold financials and energy and consumer cyclical stocks perk up to allow the growth giants to pull back. But often the resolution comes when the outperformers run out of gas and reverse, driving a flurry of broader selling and maybe a decent flush lower before a recovery. Will October low hold? Along the way this year, the market has lost the benefit of broad upside participation, something it had very much in its favor in January. The equal-weight S & P 500 is now below its December low and is lagging the standard market-cap-weighted version since the Oct. 13 market bottom. Only about 60% of the S & P 500 members are positive over the past six months even as the index is up 7.5%, a loss of internal energy. If October was the end of the bear market, the five-plus months since have been among the weakest on record for a new bull market. From a market-cycle perspective, though, nothing is yet fated. Ed Clissold, U.S. equity strategist at Ned Davis Research, points out that if indeed October proves an ultimate low, this is right about the time when the market would typically undergo a stiff test, one that seems like a bear-market relapse and depresses investor sentiment severely. Note the interesting history of October lows and successful February-March retests, in 2002-03, 2008-09 and even, to a less-dramatic degree, 2015-16. And sentiment is surely pretty skittish right now, with Goldman reporting systematic hedge funds with very low equity exposures, the most popular advice from professionals on CNBC is to "stick with quality" and a flood of money entering safer money-market funds each day. Fed near end of tightening cycle Another broad point: Whatever else transpired this month, investors now find themselves with a Fed at or near an end to its tightening cycle a good deal sooner and at a lower peak rate than they'd anticipated a mere three weeks ago. The question is "at what cost to the economy and financial stability?" We don't know. Which also means we don't know if that cost is unbearable. While the final rate hike in a cycle has over the long span of history not been a great entry point for stocks, in more recent times – since 1989 – the S & P 500 was up at least 10% four of the five cases, says Clissold. (In some cases the six-month window gave way to much rougher times.) The Atlanta Fed real-time GDP tracking number for the first quarter is close to 3%. With inflation it means nominal GDP is still in the high-single-digits, not a terrible starting point to begin deducting points for banks cutting back on lending and consumers hoarding cash. The flash S & P Global U.S. Composite PMI for March, reported Friday, was up to 53.3 from 50.1 the prior month and above the 49.5 forecast, a reading S & P says is consistent with around a 2% real GDP pace. The 30-year fixed mortgage rate is down below 6.5% from above 7% late last year and home-buying activity has already perked up. Granted, a firmer-than-expected economy right now might not be an unambiguous blessing for the market or for the longer-term growth picture. Citi strategist Scott Chronert says, "We see an emerging risk that the fundamental deterioration necessary for the Fed put to kick in might be more onerous than the market expects. In our view, this caps upside for the S & P 500 where in the coming months, better macro data is bad for equities as rate cut expectations reprice." Fair enough, it's a tricky moment. If deposit flight from banks reaccelerates, if the European bank crisis enters a nasty feedback loop of counterparty suspicion and ballooning credit spreads, it's tough to assume U.S. stocks will remain so placid. And for certain, the radically upside-down Treasury yield curve with the 2-year yield under 3.78% are granting greater conviction to the recession forecasters out there, and such things are not to be dismissed. Yet the two-year yield three weeks ago was at 5%, signaling an economic overheat and much higher rates ahead from the Fed. Was that message worth trusting unconditionally?