Here are 5 reasons why the rally in stocks 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 fizzling out after stocks jumped from oversold to overbought.

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

“There has been a lot of good news, but the market needs some pause. We moved a little too fast, too fast, right now,” Goldman said in a phone interview with MarketWatch.

To support that view, he pointed to a handful of reasons that Friday’s decline in stocks could continue into next week, and possibly longer — even as he remains bullish on stocks over the longer term.

Defense sectors are back in fashion

Cyclical sectors outperformed as stocks rallied in July and early August. But that trend appeared to end this week as defensive sectors retook the lead.

“One sign that investors are getting nervous is that cyclical sectors are underperforming defensive sectors, and we’re starting to see that now,” Goldman said.

Last week, stocks and utilities were the top two performers among the 11 sectors of the S&P 500. As a result, the XLP Consumer Staples Select Sector SPDR fund,
-0.32%,
an exchange-traded fund that tracks the sector, is up 1.9%, while the Utilities Select Sector SPDR Fund XLU,
-0.05%
gained 1.3%.

On the other hand, the two worst performing sectors were the cyclical sectors. communications materials and services. The Materials Select Sector SPDR fund XLB,
-1.84%
fell 2.4% for the week, while the Communications Services Select Sector SPDR fund XLC,
-1.62%
down 3.1%.

Bond yields are rising

Rising bond yields are another sign that the stock rally could be about to turn, Goldman said.

Higher bond yields can pose a problem for stocks because they make bonds a more attractive investment by comparison. Stocks and bonds often moved in tandem at the start of the year as expectations of tighter monetary policy from the U.S. Federal Reserve hit both assets.

But that dynamic seems to have changed in August. Bond yields turned higher earlier this month and started to rise before stocks hit an abnormal level late this week.

The yield on the 10-year bond 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 bond prices lower.

I see: Fed’s Bullard Says Leaning To Support 0.75% September Hike

So is the dollar

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

I see: The US dollar is on fire and cuts through key technical levels ‘like a hot knife through butter’

A strong dollar is generally associated with weaker stocks, as it erodes the foreign earnings of US multinationals, making them less valuable in US dollar terms.

Cryptocurrencies are falling

Cryptocurrencies like bitcoin BTCUSD,
+1.33%
and ethereum ETHUSD,
+2.94%
They’ve also been trading almost flat on stocks lately, particularly 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 might be next.

“Another sign of a market pause is weakness in crypto. It is a clear sign of a risk-off trend in the market,” Goldman said.

I see: “There is no reason to treat the cryptocurrency market any differently than other capital markets just because it uses different technology,” said SEC Chief Gary Gensler

Bitcoin fell about 9.5% on Friday, while ethereum, the second most popular cryptocurrency, fell about 10%, according to CoinDesk.

Stock valuations are out of sync with corporate earnings

Another reason the stock rally is being questioned is that there appears to be a disconnect between stock valuations and corporate earnings expectations.

As Goldman pointed out, the S&P 500’s price-to-earnings ratio has rebounded 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 fell from $238 to $230.

“Stocks rise on lower earnings estimates,” Goldman said.

Goldman isn’t alone in worrying about rising stock valuations. In a recent note to the bank’s clients, Citigroup’s US equity strategist Scott Chronert said the risk of a decline in corporate earnings towards 2023 could create a “valuation headwind” for the shares.

“We would say that regular selling to a larger power is justified,” he said.

US stocks fell on Friday, with the S&P 500 SPX,
-1.29%
falling 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 by 292.30 points, or 0.9%, to 33,706.74.

Friday’s stock losses pushed all three major stock benchmarks 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 will also deliver his annual address from the Kansas City Fed’s annual symposium in Jackson Hole, Wyo. Economists expect he will use the opportunity to emphasize the Fed’s commitment to fighting inflation.

I see: Powell to tell Jackson Hole recession won’t end Fed’s fight against high inflation

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

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