Stocks are hostage to the round numbers

Arbitrary round numbers matter, even though they shouldn’t. The definition of a “bear market” as any peak-to-trough drawdown of 20% or more is unhelpful. The difference between losses of 19.95% and 20.05% is minimal. But the definition is often cited, and it has an impact on how people behave. Which brings us to Friday’s trading, when the proximity of the 20% landmark combined with options expiry to create some fun.
At the start of Friday, news that China was easing monetary policy gave everyone an excuse to buy, but disappointing earnings from Deere & Co counteracted that. After rising at the open, the S&P steadily sank. Then with one big dive, it dropped into a bear market. For 20 minutes or so, traders tested the bear market line, and when no rally would hold the index juddered lower. In the afternoon, the dip-buyers arrived, but again the bear market line proved a barrier, and the index dropped after reaching it.
Then as trading ticked up in the last hour, the index broke through the line, and rallied swiftly until it reached the close. It bounced backward a couple of times, before ending the day infinitesimally higher than it started. Last week was a fascinating exercise in crowd psychology applied to trading. It didn’t reveal anything new about whether this is a true bear market.
The last few weeks haven’t seen any great recovery for stocks, but there are clear signs of a rethink of what kind of selloff this is. We can trace this in the relative performance of equities and bonds, proxied here using the relative performance of the “SPY” and “TLT” exchange-traded funds, which respectively track the S&P 500 and an index of long-dated Treasuries.
Back in January, stocks sold off far more than bonds. Changing views of the Fed suggested that the “There Is No Alternative” to equities story would have to be abandoned, and that meant getting out. They rebounded after the opening week of the war in Ukraine to outperform massively, beating bonds by more than 20% by the peak in late April. But the last two weeks have reintroduced the idea that bonds may be a better bet.
There are two broad catalysts. One is the growing fear that the Fed won’t be able to tighten as much as it wants, and will instead have to reverse course. If that is true, then bonds yielding about 3% begin to look attractive. The second catalyst is corporate earnings. Generally good announcements in April helped buoy the stock market (although punishment for the likes of Netflix Inc and Amazon.com showed minimal tolerance for risks). But in the last week retailers have been announcing, and investors hate what they’ve heard. If retailers, and manufacturers like Deere, are finding it harder to make a profit, that takes away the remaining prop for share valuations.
Will the broader S&P 500 lapse into a true bear market? That seems by far the most likely outcome. If it is to be avoided, we would need to see inflation start to decline fast, and the Fed step back from its aggressive hawkishness, while avoiding any more ugly geopolitical surprises.
Then we’d need some confirmation three months from now that companies can indeed keep growing their profits. It’s possible, but on balance unlikely.

—Bloomberg