Market action so far today is a matter of perspective. If you’re old school, watching the Dow Jones Industrial Average (INDU), today is a solid day, with that measure rising by over 3/4%. Not bad. As I write this, the S&P 500 Index (SPX) is back to trading roughly flat after a brief flirtation with minor declines. Yet the NASDAQ 100 Index (NDX) is over 1.5% lower, giving back all its Friday gains and then some. What gives?
The short answers are rotation and inflation. Tech stocks are out of favor today as investors digest the potential for inflationary ramifications arising from Friday’s payrolls report. We can debate whether inflation is itself a drag on tech shares, but we would certainly assert that the valuation of the highest-flying tech stocks is dependent upon monetary accommodation and low interest rates. The lower the prevailing interest rate, the higher the present value of future income streams and cash flows. When we consider that the most popular tech stocks trade at historically high valuation measures, anything that threatens those valuations becomes a negative. Higher inflationary expectations and/or a pause by the Fed are viewed as potential threats by tech investors. Because the vast majority of NDX’s weight is in tech stocks, a broad tech selloff is by necessity a drag on NDX.
Inflation has been a recurring theme in this space for several days. On Wednesday and Thursday we explained how the mechanics of commodity futures market could explain the Federal Reserve’s view that current inflationary pressures are transitory. Many of the sharpest rises in traded commodities have pushed their futures markets into backwardation, a situation that implies that short-term supply shortages are likely to ease over time. We also noted that the Fed seemed to be overlooking that even in backwardation, the futures markets are often anticipating significantly higher commodity prices over last year. Our conclusion ahead of the payrolls report was that the Fed would be comfortable with the consensus outlook for about 1 million new jobs and no increase in hourly wages, while a “significant deviation in either of those statistics (or the others that will be reported) could surprise investors and change the tone of the inflationary debate.”
The numbers were indeed a surprise, and they were taken positively. As we noted on Friday, after the market had some time to digest the reports, investors were more than willing to overlook a negative headline surprise because the “payrolls miss certainly appears to push back the timing of full employment, thus keeping the monetary accommodation in place.” There is no more powerful narrative for investors than that of an accommodative central bank, so while it may have been superficially surprising that equity markets rose in the face of a set of negative numbers, the rise was easily explained. Today, however, we are seeing investors look past the simple narrative and think a bit more deeply about the inflationary ramifications of the combination of a relatively stagnant labor market combined with startlingly higher wage growth.
On Friday, we suspected that “If we combine the ideas that labor costs may be rising along with the obvious increases in commodity prices, it is not difficult to consider that inflationary pressures may be spilling into the economy at a quicker pace than investors are anticipating.” For NDX, at least, those concerns have come into sharper focus today.
Clearly all is not is all lost for investors, though. Different indices are weighted differently, and while NDX is dominated by companies that would have their valuations inordinately impacted by rising inflationary expectations, INDU has many companies that can benefit from rising prices. (Never mind my continued assertion that INDU is a poorly constructed measure with a roughly random weighting) Inflationary expectations boost long-term bond yields, and the resulting steeper yield curve benefits banks like Goldman Sachs (GS) and JP Morgan (JPM). Consumer products companies like Home Depot (HD), Wal-Mart (WMT), and Disney (DIS) can likely pass along higher input prices to customers who have more disposable income. All those are INDU components, and all are higher today. Yet we see from a flat SPX that the gains across consumer-focused sectors are being largely offset by the decline in large tech shares.
What we see today is a clear look at market rotation. It is particularly obvious today because the stocks that are getting hit the hardest are the largest and most widely held. Whether today’s rotation continues in its current form remains to be seen, but rotation is usually in evidence somewhere. Traders are always looking for sectors or stocks that are undervalued relative to others. As before, the outcome is somewhat in the hands of the Federal Reserve. If they become more concerned about inflation, as many investors have, that could have severe ramifications for a liquidity-dependent market. That said, until or unless they indeed indicate that inflation concerns could influence their activities, we are likely to see fickle traders and investors chasing themes rather than completely exiting equities.
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