The pain tolerance of stock bulls may be formidable, but it isn’t endless.
That became apparent Friday, when after standing firm against a week’s worth of steadily worsening news, major indexes finally gave up weekly gains and slipped resoundingly into the red. Two days of Federal Reserve hectoring softened resolve before a dose of geopolitical panic pushed the S&P 500 down 75 points and capped the biggest two-day drop in 16 months.
In the end, the heft of the pressure brought to bear against a market that at times this week traded within 5% of a record became too great. Fed policy makers, emboldened by the worst inflation in four decades, upped their hawkish rhetoric. On Friday, National Security Advisor Jake Sullivan said the U.S. believes Russia could take offensive military action or attempt to spark a conflict inside Ukraine as early as next week.
It was like “a combination punch that felled a heavyweight boxer,” said Sam Stovall, chief investment strategist at CFRA. “So you had higher CPI, you had hawkish comments by a voting Fed member, combined with elevated geopolitical tensions, and those three have knocked the bull down for the count.”
Thursday and Friday’s selling represented the worst break in a two-week rebound that at times seemed to suggest investors were finding ways to live with the turn in the Fed’s hiking cycle. Even with the plunge, an equal-weighted version of the S&P 500 ended the week only down 0.2%, testament to the market’s buoyancy since its worst January since 2009.
The losses halted two weeks of gains, with very different forces exerting pressure on bulls. Thursday brought a massive selloff in Treasuries that sent rates higher after U.S. consumer prices showed the fastest increase since in 1982 and St. Louis Fed President James Bullard called for a concerted pace of policy tightening. Friday’s rout saw investors pour into the safety of bonds at the expense of riskier assets.
The S&P 500 dropped 1.8% over five days, while the tech-heavy Nasdaq 100 slumped 3%. The Cboe Volatility Index, a gauge of cost of S&P 500 options also known as VIX, jumped almost 5 points to 28.
On Friday, Sullivan said conflict around Ukraine “could begin during the Olympics despite a lot of speculation that it could only happen after” the Winter Games end. Russia has repeatedly rejected charges it plans to invade Ukraine, and the U.S. doesn’t believe President Vladimir Putin “has made any kind of final decision,” Sullivan said.
It was all bad timing for bulls who had just piled into stocks. U.S. large-cap funds attracted $34.1 billion in the week to Feb. 9, the most ever, EPFR Global data compiled by Bank of America Corp. show. The inflows arrived amid withdrawals from fixed-income funds and cash products.
At the same time, it represented a reprieve for hedge fund bears, who thought they spied an opening, laying down bets on a decline at the fastest clip in more than a decade. While a mammoth short squeeze on Tuesday and Wednesday sent their favorite targets up almost 7%, the late-week slump was rewarding to those who stuck around.
The robust demand for equity funds likely reflected pain among fixed-income investors. Down almost 4% so far in 2022, U.S. Treasuries could well close out the year in the red at this rate, in what would be the first back-to-back annual losses in history.
To Rich Weiss, chief investment officer of multi-asset strategies at American Century Investments, the equity inflow is a sign of investor complacency. With rates rising at a time when profit growth is estimated to slow this year, the backdrop is not constructive for equities either.
“I do not think stocks are a safe haven for bonds in a rising interest rate environment,” he said. “It may not be a good environment with rising rates for bonds, but it’s probably worse for stocks.”
For all the angst over rate hikes, there are few signs of stress in the equity market. A basket of stocks with weak balance sheets, for instance, beat its strong counterpart for a ninth week in 12, data compiled by Goldman Sachs Group Inc. show.
From airlines to cruise lines, companies exposed to the prospect of a return to normalcy saw their shares advance as states from New York to New Jersey eased restrictions on masking. A basket of reopening stocks jumped 1.8% over the week.
While higher rates create pressure on valuations, there is a prevailing faith that a strong economy will keep the bull market alive. Among S&P 500 firms that reported quarterly results, 76% exceeded analysts’ profit estimates, data compiled by Bloomberg Intelligence show.
“The bull market is sustained because we’re going to have strong economic growth and decent earnings growth,” David Donabedian, chief investment officer of CIBC Private Wealth Management, said by phone. “There’s nothing about the level of interest rates over the next couple of years that says, ‘Oh clearly that’s the road to a bear market.’”
But the market is struggling to reclaim its lost ground. Twice this month, the benchmark attempted to break above its 100-day average, and both times, it failed to hold.
Anxiety around what the Fed will do may have receded slightly, but this week’s market volatility “is evidence that it’s not gone,” said Jason Pride, chief investment officer of private wealth at Glenmede. “The market’s not fully on stable ground on this discussion point.”