Vertigo: Market Succumbs to Myriad Pressures

Those truisms have been in and out of play this year, with the strong equity market rally off last October's lows sometimes begging the question of whether the market was fighting the Fed. The (up)trend had certainly befriended many equity investors. What's interesting is that on Marty's list of trading rules, number six specifically read: "Don't fight the Fed (less valid than #1).

As July came to a close, the S&P 500 was less than 5% from its early-2022 record high. What changed?

• Treasury yields surged to their highest levels since the period before the Global Financial Crisis;
• Increased focus on the federal budget deficit, high debt levels and the elevating cost of servicing the debt;
• U.S. economic growth has surprised on the upside, while inflation remains sticky (bringing Federal Reserve rate hikes potentially back into the picture);
• Concerns about the ripple effect of China's weak economic growth;
• S&P 500 earnings did not surprise into positive growth territory and forward estimates have been trending lower;
• Investor sentiment had become a bit frothy alongside elevated valuations.

Related to earnings, all of the appreciation in the stock market since last October came from multiple (P/E) expansion, with no aid from the denominator in the equation (earnings). Add the surge in yields into the mix and it was a recipe for a pullback—particularly among the most richly valued segments of the market.

The surge in yields is partly explained by increased supply of Treasuries associated with the burgeoning federal budget deficit, which brings with it rising debt servicing costs. This finally seems to be capturing the market's attention. As we posited in our 2023 outlook report, written late last year, government indebtedness and its costs will be a growing part of the macro conversation. We will be writing more on this topic in future reports, so stay tuned.

To explain further, we'll link to a report we wrote in March, in which we discussed an important rebalance that took place in December 2022 for the S&P Growth and Value Indexes. We'll focus on the Pure Growth Index in this report given it houses stocks that cannot exist in the Pure Value Index, and because the "growth trade" has come into focus this year—accentuated by the significant outperformance (until June) of large-cap stocks and indexes that are often considered to be in the growth family.

After the December 2022 rebalance of S&P 500 Pure Growth, all but one of the "mega-cap eight" stocks stayed in the index: Apple. All others (such as NVIDIA, Tesla, and Microsoft, etc.) were moved out. At that point, Technology had gone from representing 37% of the S&P 500 Pure Growth index to only 13%. The inclusion of more Energy stocks—given their outsized earnings growth last year—brought that sector to the top of the list of represented sectors in the Pure Growth index, with Health Care moving to the number two spot.

So, here's where it gets interesting now that we find ourselves with year-to-date performance that has still been dominated by the largest "growth" stocks (for example, NVIDIA is up by nearly 200%). Any group of investors would likely still consider the mega-cap eight to be growth stocks today, yet given the nature of December's index rebalancing, they are missing from S&P 500 Pure Growth despite their huge runs this year.

As such, as shown below, S&P 500 Pure Growth has underperformed the Tech-heavy NASDAQ 100 considerably year-to-date, with the former up only 2.1% and the latter up a whopping 34.3%. For two indexes that essentially moved in lockstep last year—and that are often considered to be emblematic of the large-cap growth trade—the split in performance this year is glaring. Not only that, but this has occurred even after the NASDAQ 100 underwent its own special rebalance in July, which diluted the weights of the mega cap names.