In early August, equity volatility spiked to levels last seen in 2020, reflecting market jitters that started emerging in late July. Volatility has since retreated with the VIX falling back to more typical levels. However, this spike could be a harbinger of further turbulence and a preview of what could come if investors finally pivot away from the Magnificent Seven. Broad market indices regained some footing as the month progressed, but not without some blemishes. Is it time to say “We’re So Back?”
Bond market volatility remains high, with the MOVE Index sitting near the 81st percentile when compared to the past 10 years. This elevated level is a reflection of ongoing uncertainty surrounding interest rates. Considering Powell indicated a September rate cut is in the cards, the market now grapples with the number of expected rate cuts with bond volatility likely to persist at these heightened levels for the foreseeable future. The 2s10s U.S. Treasury curve flirting again with un-inversion is not helping either.
Despite challenges in the broader economy, investors betting on growth stocks have been handsomely rewarded, while those looking for value have faced a more difficult road. Looking at the year-to-date performance of the Russell Top 200 Pure Growth (mega cap growth) versus the Russell 2000 Pure Value (small cap value) paints an interesting picture of the failed rotation in action.
After initial fits and starts in January, growth started outperforming value as the first quarter progressed. By April, Growth was consistently outperforming, even as both growth and value faced broader market volatility. Growth stocks demonstrated their resilience, capitalizing on AI optimism. Meanwhile, value stocks struggled, unable to keep pace in an environment that favored growth narratives.
Growth and Value continued to grapple for market leadership through June and July. Despite some pronounced bouts of leadership from both styles, the edge remains in Growth’s favor after a turbulent August.
For the Magnificent Seven, it is getting lonelier at the top. From a market leadership perspective, participation is narrowing. AAPL and META remain in the best position as relative leaders while Microsoft, Amazon and Alphabet are making fresh relative lows against the S&P 500. Nvidia and Tesla are also deteriorating. Will a pronounced degradation in leadership catalyze a broader downturn for Growth equities?
Of course, the million dollar question is what it will take for Value to see a sustained period of outperformance. For now, investors believe the main market driver is rate cuts driven by moderating inflation amid an economic soft landing.
Taking a step back, investors may be better focused on the health of the overall market. The current trajectory of U.S. earnings revisions paints an ambiguous picture, as revisions are neither decisively bullish nor bearish. The 12-week average of net earnings revisions has remained close to zero for an extended period, indicating a lack of strong momentum in either direction. This tepid outlook reflects a market in a state of uncertainty, where earnings expectations are not providing clear signals in either direction.
A rapid steepening of the 2s10s yield curve could be a sign of trouble brewing. The below table reviews four periods when the yield curve sharply un-inverted. On average, the S&P 500 falls 3.9% over the subsequent six months while Health Care and Staples tend to take the baton of defensive sector leadership. Interestingly, Tech saw two periods with sizable underperformance and two with sizable outperformance. Investors may be well served by being more selective in the coming months, especially with all eyes on the September 18th Fed meeting.
In conclusion, while the recent spike in equity volatility and the persistent turbulence in the bond market signal that we are navigating uncertain times, we do not believe there is an immediate cause for panic (even with September’s poor seasonal history). The economic environment remains mixed, with some sectors showing strength while others struggle. This has created a landscape where volatility may indeed become more pronounced, especially as markets continue to react to evolving narratives around the jobs outlook deteriorating, but not falling off a cliff.
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