Right on schedule, the first week of August began our annual pilgrimage into the dog days of summer. That means less investor participation as Wall Street packs up for summer vacations, creating environments where stocks can move up or down more easily.
For some this may cause seasonal anxiety. So, today we at Cornerstone want to explain what we’re seeing in the underlying data and why it’s not unnerving for us (it makes sense and was expected).
First, we want to flag three points of interest from last week.
1.The president announced he would name the next Federal Reserve chair by the end of the week.
Markets didn’t seem to react negatively because it’s been foreshadowed for a while. We think the market will view the new candidate as the leading “shadow voice” of a more doveish monetary policy, which is seen as positive for stocks.
2. The July ISM Services report, which reflects prices paid by producers, gave a bearish feeling to many pundits as the headline missed expectations and prices paid rose:
What really matters isn’t the report itself, but the reaction to the report from bond markets.
Interestingly, this data release didn’t change the expected cuts for the federal funds rate for the rest of the year:
In fact, 10-year Treasury yields kept trending lower to right around 4.2%, whereas we were at 4.57% to start the year:
This indicates the bond market still doesn’t believe any real, sustainable inflation is imminent.
3. Goldman Sachs Prime Brokerage data indicates gross exposure to equity markets has declined significantly in the past couple of weeks:
This reflects the beginning of a macro cautiousness by traders going into August seasonal weakness. This level of cautious trade unwinding is in line with seasonal timing expectations (i.e., vacations) and aligns with additional money flow data discussed below.
But while it was expected to us, this is likely to foreshadow short-term volatility for the next four to six weeks. Thankfully, it’s not indicative of intermediate- or long-term doom and gloom. We see historical patterns like this consistently.
The most prominent recent example of this price action following de-risking at extreme levels was in March 2020, when the S&P 500* took off following COVID capitulation:
This may seem like a sharp data reversal considering the end of July indicated all was well and nothing could derail market progress. After all:
- Companies kept reporting downright impressive earnings,
- Gross domestic product was well above expectations,
- Consumer confidence for July was high and above forecasts,
- Inflation was in line, and
- Treasury auctions saw robust demand.
And that’s just a handful of the good news over the last few weeks.
This market strength was especially noticeable as bond yields fell due to the strength of the Treasury auction. For example, the bid-to-cover ratio for the recent $39 billion 10-year Treasury auction was 2.67, up from 2.59 in the previous auction.
This means investors submitted $2.67 in bids for every $1.00 of debt offered. For perspective, a ratio above 2.5 is considered extremely healthy.
This strength was one of the catalysts supporting the yield on the benchmark 10-year Treasury knifing lower, settling around the 4.20% level, even though the Fed left rates unchanged:
The next Fed meeting is six weeks away, which feels like a lifetime. As such, it further opens the door for a possible 50-basis-point cut. That would be a big tailwind for bonds and equities and build on the impressive foundation set by corporate earnings.
Earnings
As of last week, 82% of S&P 500 companies reported positive per-share earnings surprises and 79% reported positive revenue surprises:
More importantly, the blended year-over-year earnings growth rate now sits at 10.3%:
This is extraordinarily impressive considering the EPS growth rate was 6.5% a week ago. It’s even more impressive since the estimated growth rate was a mere 4.9% at the start of earnings season.
If this rate holds, it will mark the third consecutive quarter of double-digit growth that’s being led by some of the key components of the “Magnificent 7” and the financials sector overall.
While there are new uncertainties as we enter seasonal weakness, the direction of pricing is more certain with two asset classes: fixed income and dividend equities.
This is reflected by the significant pivots on Friday, Aug. 1, when bond traders basically “backed up the truck” on Treasuries. That’s a long-awaited signal for income investors to begin to secure higher yields and benefit from price appreciation in the coming months.
Uncoincidentally, the CME Fed Watch tool quickly adjusted target probabilities of the Fed funds rate moving lower by 75 basis points by year end:
This is also reflected in the price action of the exchange-traded fund iShares Iboxx Investment Grade Corporate Bond ETF (LQD), which is the largest investment grade corporate bond fund:
The chart above shows how LQD is about to put in a “golden cross,” where the 20-day and 50-day moving averages move up through the 200-day moving average. This indicates the odds of fixed-income assets and other dividend producing assets gaining strength through the end of the year have significantly improved in less than a week.
We see this dividend stock strength further reflected in sector rankings, where suddenly utilities top the list:
This is due to the strength of the sector’s qualified dividends and surprisingly strong technical momentum ratings. The momentum stems from the huge spending spree happening to transition our energy grid to power AI at scale (which is why we began to incorporate utilities in our equity portfolios back in January).
As this action continues, it could be the catalyst for funds to finally begin shifting out of money markets. Future lower yields won’t be able to compete with fixed income and dividend stocks.
“Big Money”
Wrapping up this admittedly long post, readers who’ve been with us for a while know we’d prefer to shut down the markets for August and September to avoid volatility and enjoy summer. In other words, we’re entering the sloppiest time of the year for stocks, historically:
And right on time, the first week of August marked an abrupt change in the underlying character and data of the market. From April 10, the day after the reciprocal tariff pause went into place, until the end of July, the ratio of inflows to outflows was a robust 3.6:
Once August hit, there was a sharp reversal:
From another perspective, you can see how April-July inflows were strong and broad:
In the first trading week of August, the pattern changed:
It caused MoneyFlows’ trusty Big Money Index (BMI), a 25-day moving average of netted “big money” investor activity, to fall from overbought levels all the way down to 68.1%:
While the market itself hasn’t shown weakness yet, that’s normal. Market prices tend to lag money flow data slightly. If the past holds true, market pricing will begin to show weakness beginning somewhere around the middle of August. It typically happens when there are heavy ETF outflows, but that isn’t happening yet.
So, it appears our expectation of a bumpy August is beginning to take form. It’s what guided our decisions in our quarterly rebalancing to tweak our dividend equities and extend our bond durations to be more resilient through the seasonal weakness.
Remember, the fundamental data foundation remains supportive. The long-term trend is bullish. Corporate earnings are strong and well above averages:
Yes, seasonal volatility provides a headwind. But it’s temporary. There is still ample runway for a strong finish in the back end of the year.
We need to remember that gyrations are part of the rhythm of the market. There's no reason to let a little August choppiness ruin anyone’s perspective.
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