Economic & Market Report: Leaves Turning Brown

The U.S. stock market continues to hold its ground as summer gradually turns to fall across capital markets.  While the headline benchmark S&P 500 Index has been middling at best since the end of July, its overall performance over the past year has been impressive and if anything stocks are continuing to hold their ground following particularly strong early summer gains.  With that said, a few metrics a worth watching as the seasons change from summer to fall for potential early signs of downside risk.

Waning speculative fervor. Liquidity driven speculation has been a particular driver of stock market returns during prolonged stretches for more than a decade now.  A useful metric to measure the speculative appetite among investors has been the price of cryptocurrencies such as Bitcoin, which has had a notably strong correlation with the tech heavy NASDAQ 100 since the mid-2010s.

What has been increasingly notable since the early spring is the widening divergence between Bitcoin and the NASDAQ 100.  For a while the tech heavy index has marched higher driven by the mega cap “Magnificent Seven” of Apple, Microsoft, Amazon, Alphabet, NVIDIA, Meta, and Tesla.  Bitcoin prices have been sideways at best and increasingly fading as of late.  Such deviations have eventually reconverged over much of the past decade, typically with Bitcoin falling back down to the path of the NASDAQ 100.  It will be interesting to see whether it might be the NASDAQ 100 catching down to Bitcoin prices this time around.

Maples versus oaks.  Just as the leaves of maple trees typically turn before those of oak trees, so too have small cap stocks historically led the performance of large cap stocks.  Small caps frequently lead their larger counterparts to the upside shifting into expansions, and they also typically lead the trail to the downside heading into slowdowns and recessions.

Today, we see that while large caps continue to perform strongly coming off of the October 2022 lows, the initial spark of small caps has increasingly trailed off.  Perhaps small caps will eventually regain their verve and catch up to the upside.  Conversely, it will be worth watching whether the languid performance of small caps is ultimately a harbinger for both large caps and the broader market.

Falling leaves.  A third notable development has been the notable rise in corporate defaults so far this year.  As of August 2023, we have seen the number of corporate bankruptcies spike to their highest levels since the outbreak of the COVID pandemic and the Great Financial Crisis before that.  Moreover, the number of bankruptcies today exceed the totals seen during the bursting of the technology bubble at the turn of the millennium.

But unlike these past episodes when the spreads between high yield corporate bonds and comparably dated U.S. Treasuries widened out to reflect the additional yield required by investors to take on the additional risk including the threat of default that comes with owning more speculative corporate debt, these readings remain largely unmoved today.  In fact, spreads are continuing to marginally narrow if anything.  Whether this is a notable sign of justified confidence or misguided hubris among investors remains to be seen, but we should continue to watch high yield credit spreads in the months ahead, for any such rise to catch up to the trend implied by recent bankruptcy would provide an early warning signal for potential downside pressure eventually making its way to the stock market.

Bottom line.  Risks are almost always prevalent in any market environment, and today is certainly no exception as we make our way from summer to fall.  And while I would not rank any of the risks detailed here as imminent threats to the nearly year long stock market rebound, they warrant monitoring in the weeks ahead for any signs of decay as we travel our way through what historically can be the most unsettled time of the year for U.S. stocks.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Investment advice offered through Great Valley Advisor Group (GVA), a Registered Investment Advisor. I am solely an investment advisor representative of Great Valley Advisor Group, and not affiliated with LPL Financial. Any opinions or views expressed by me are not those of LPL Financial. This is not intended to be used as tax or legal advice.  All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.  Please consult a tax or legal professional for specific information and advice.