Stocks’ unshakeable optimism

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

Good morning. If you had a long weekend, we hope it was fun, and not too hot (sorry, Londoners) or soggy (New Yorkers). The weekend news has been all about Iran. Do we have a deal? If so, who’s the “winner”? Markets seem fine with the ambiguity. Brent has crept under $100 a barrel. But if you’re confident that energy costs slide smoothly from here, enabling borrowing costs to float lower too, you’re braver than us. Email us: [email protected].

Earth to stocks, come in stocks

I’m relieved to see it’s not just me who is wondering when stock markets will get the memo from bonds that all is not well in the world.

In fairness, higher yields are rumbling stocks a bit. You just have to look beyond the S&P 500, and a little beneath its surface. This is obvious even to those with an admirable, indefatigable optimism about the asset class — a tribe that includes Max Kettner and the rest of the multi-asset crew at HSBC, which has been touting a “tactically max” overweight in stocks for some time.

It’s been a great call, but in a note last week, HSBC said higher yields are indeed “taking a toll” on risk assets. The S&P 500’s gains have been very narrowly concentrated around the AI theme, with the equal-weighted version of the index flattish since February. The analysts add that the bleeding edges of markets have proven sensitive to yields: “High-beta US momentum stocks sold off by more than 18 per cent between 13-19 May when the US 10-year sold off. High-beta and emerging market stocks have clearly been impacted too. In credit we see a similar dynamic.”

This is true, but only at the margin. Broad risk appetite has proven resilient to the recent ascent in bond yields. I mean, look at SpaceX’s initial public offering documents (if you dare). And in just the past few days, the S&P 500 has broadened notably, with the equal-weight index outperforming, a sign that risk appetite is increasing:

Investors are offered a choice between focusing on the threat of inflation and the crushing weight of debt servicing costs in developed markets (try on a possible extra £15bn this fiscal year in UK debt servicing costs, for starters), or concentrating instead on the prospects for an imminent reopening of the Strait of Hormuz and an AI boom that does not stop until there are data centres in space and permanently higher productivity growth back on earth. They prefer the bright side.

Who can blame them? The bright side has been the place to be for years. Our friends at Absolute Strategy Research note the S&P 500 has more than doubled since October 2022. It’s up 900 per cent since the great financial crisis (I checked that twice to make sure it’s not a typo).

Maybe stock markets are full of dumb money and as long as dumb money keeps entering the market — especially in the form of passive, index-tracking products — then everything will be OK. It’s all about flows, not fundamentals. This is the view of short seller Carson Block, who I interviewed last week. It is not intended as a swipe at uninformed investors. The dumb money is looking pretty smart right now.

But if the AI boom should disappoint, even a little? Or the strait remain closed through the summer, leading both inflation and rates higher? Then it will turn out we have been enjoying the bull market’s last hurrah. As my colleague Tej Parikh pointed out over the weekend, in the past, flurries of big IPOs have tended to coincide with market tops, as the supply of stocks begins to grow faster than demand. And we are having just such a flurry now.

Here’s Ian Harnett at ASR:

Calling the peak for equity markets is, potentially, much harder than identifying the troughs of bear markets. Since equities are nominal variables and are linked with rising ‘nominal’ earnings they naturally trend higher. This, almost by definition, makes bull-market peaks harder to identify — especially in advance — and especially as multiple key ‘reversal catalysts’ are often involved.

Stocks are expensive right now by any measure, and retail participation is heavy — both of which feel unnerving, but do not represent reversal catalysts. Valuations don’t help with market timing and retail demand needs a reason to fall. What could be the trigger? By definition, the market won’t see it coming; if it did, it would be smoothly priced in. A cyber event? (Anthropic’s Mythos AI model keeps coming up in my conversations with investors and policy types.) A parabolic ascent in energy prices? Pick a card, any card.

One thing we can be sure of, however, is that tightening monetary and fiscal policy will make the market more sensitive to unexpected negative surprises. Harnett again:

Given that the two key factors supporting equities are strong earnings growth and the continued support from the lagged effects of easier monetary (and fiscal) policy on liquidity, these are the areas where the weakness will need to come from. It is not a coincidence, in our view, that the tech bubble burst within 12 months of US rates being hiked in 1999, in response to stronger commodity prices.

Over to you, Kevin Warsh.

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