Here are 5 reasons why stocks’ rally may be about to turn into a bear market again

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Aug 20, 2022 , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,
Here are 5 reasons why stocks' rally may be about to turn into a bear market again

Some market gurus are beginning to worry that Wall Street’s summer rally may be coming to a halt after stocks quickly swung from oversold to overbought.

Gene Goldman, chief investment officer of Cetera Financial Group, explained that stocks are likely headed for a pullback even though the economy is in better shape than many Americans realize.

“There’s a lot of great news, but the market needs a bit of a break.” We were moving too fast, too fast right now,” Goldman said in a phone call with MarketWatch.

To support that view, he cited several reasons why Friday’s decline in stocks could continue into next week and possibly longer — though he remains bullish on stocks over the longer term.

Defense sectors are back in fashion

Cyclical sectors fared better as stocks rallied in July and early August. But that trend appears to have come to an end this week as defense sectors once again took the lead.

“One sign that investors are getting nervous is cyclicals not doing well in defensive sectors, and we’re starting to see that now,” Goldman said.

Over the past week, consumer staples and utilities stocks were the top two performers among the 11 sectors of the S&P 500. As a result, the Consumer Staples Select Sector SPDR
XLP,
-0.32%
,
an exchange-traded fund that tracks the sector rose 1.9%, while the Utilities Select Sector SPDR Fund
XLU,
-0.05%

gained 1.3%.

On the other hand, the two worst performing sectors are materials and communication services, two cyclical sectors. Materials Sector Select SPDR Fund
XLB,
-1.84%

fell 2.4% for the week, while the Select Sector Communications Services SPDR Fund
XLC,
-1.62%

down 3.1%.

Bond yields are rising

The rise in bond yields is another sign that the stock rally may be reversing, Goldman said.

Higher yields on government bonds can pose a problem for stocks because they make bonds a more attractive investment compared to them. Stocks and bonds often moved in unison at the start of the year as expectations of tighter monetary policy from the Federal Reserve rattled both assets.

But that dynamic appears to have changed in August. Treasury yields rose earlier this month and started to climb before stocks hit a rough patch late this week.

The yield on 10-year government bonds
TMUBMUSD10Y,
2.973%

up 35 basis points since August 1 and up 14 basis points since Monday to 2.897%.

Bond yields are rising as prices fall, and Goldman and others on Wall Street are now waiting to see if stocks will follow lower bond prices.

Look: The Fed’s Bullard says he is inclined to support a 0.75 percentage point hike in September

The dollar too

Rising government bond yields and softening inflation helped lift the U.S. dollar, creating another potential headwind for stocks. The US Dollar Index ICE
dxy,
+0.58%
,
a gauge of the dollar’s strength against a basket of peers, topped 108 on Friday, rising to its strongest level in a month.

Look: US dollar on fire, cutting through key technical levels ‘like a hot knife through butter’

A strong dollar is usually associated with weaker stocks because it erodes the foreign earnings of US multinationals, making them worth less in US dollars.

Cryptocurrencies are falling

Cryptocurrencies like Bitcoin
BTC USD,
+0.09%

and ethereum
ETH USD,
-3.29%

have also been trading almost in lockstep with stocks lately, especially megacap tech stocks like Meta Platforms Inc.
META,
-3.84%

and Netflix Inc.
NFLX,
-1.64%
.
But cryptocurrencies sold off sharply on Friday, leading some to wonder if stocks could be next.

“Another sign of a market pause is crypto weakness. This is a clear sign of a de-risking trend in the market,” Goldman said.

Bitcoin fell about 9.5% on Friday, while ethereum, the second most popular cryptocurrency, lost about 10.0%, according to CoinDesk.

Equity valuations are out of sync with corporate earnings

Another reason to question the stock rally is that there appears to be a gap between stock valuations and corporate earnings expectations.

As Goldman pointed out, the S&P 500’s price-to-earnings ratio has recovered to 18.6 times forward earnings, from a low of 15.5 in mid-June. At the same time, expectations for corporate earnings from these same companies over the next 12 months have fallen from $238 to $230.

“Stocks rise on bearish earnings forecasts,” Goldman said.

Goldman is hardly the only one worried about rising stock valuations. In a recent note to the bank’s clients, Citigroup’s US equity strategist Scott Kronert said the risk of a decline in corporate earnings in 2023 could create a “valuation headwind” for the stock.

“We would say that the tactical sale for additional force is justified,” he said.

US stocks fell on Friday with the S&P 500
SPX,
-1.29%

fell 55.26 points, or 1.3%, to 4,228.48, while the Nasdaq Composite
comp,
-2.01%

lost 260.13 points, or 2%, to 12,705.22. The Dow Jones Industrial Average
DJIA,
-0.86%

fell 292.30 points, or 0.9%, to 33,706.74.

Stock losses on Friday pushed all three major indexes into the red for the week, marking the first weekly decline for the S&P 500 and Nasdaq in a month.

The highlights of next week’s economic data calendar are expected to arrive on Friday, when Federal Reserve Chairman Jerome Powell is due to deliver his annual speech from the central bank’s economic symposium in Jackson Hole, Wyo. Economists expect he will use the opportunity to highlight the Fed’s commitment to fighting inflation.

Look: Powell to tell Jackson Hole recession won’t stop Fed’s fight against high inflation

In addition to the hearing from Powell, investors will get an update on the pace of inflation via the personal consumer spending index, the Fed’s preferred gauge of price pressures. The closely watched University of Michigan sentiment survey, which includes data on consumer inflation expectations, is also on the calendar for Friday.

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