Here are 5 reasons why the bull run in stocks may be turning back into a bear market

Some market gurus are beginning to worry that the summer rally on Wall Street may be starting to falter, after stocks have fallen from oversold to overbought.

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

“There has been a lot of good news, but the market needs a little break. We’ve 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 why Friday’s decline in stocks could continue into next week, and possibly longer — even as he remains bullish on stocks over the longer term.

Defensive sectors back in fashion

Cyclical sectors outperformed as stocks rose in July and early August. But that trend appeared to end this week, as defensive sectors took the lead again.

“One sign that investors are getting nervous is cyclical companies underperforming in defensive sectors, and we̵[ads1]7;re starting to see that now,” Goldman said.

Over the past week, grocery stocks and utilities were two of the best performers among the S&P 500’s 11 sectors. As a result, the Consumer Staples Select Sector SPDR fund XLP,
an exchange-traded fund that tracks the sector, has risen 1.9%, while the Utilities Select Sector SPDR Fund XLU,
increased by 1.3 percent.

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

Bond yields are rising

Rising bond yields are another sign that the rally in stocks may be about to reverse, Goldman said.

Higher government interest rates can pose a problem for stocks because they make bonds a more attractive investment by comparison. Stocks and bonds often moved in unison until the start of the year, as expectations of tighter monetary policy from the Federal Reserve sent both assets crashing.

But that dynamic appears to have changed in August. Treasury yields rose earlier this month and began rising before stocks hit a rough patch late this week.

The interest rate on the 10-year government bond TMUBMUSD10Y,
up 35 basis points since August 1, and up 14 basis points since Monday to 2.897%.

Bond yields rise as prices fall, and Goldman and others on Wall Street are now waiting to see if stocks will follow bond prices lower.

See: The Fed’s Bullard says he is leaning toward supporting a 0.75 percentage point hike in September

So is the dollar

Rising government interest rates and softer inflation have helped drive the US dollar higher, creating another potential headwind for stocks. ICE US Dollar Index DXY,
a gauge of the dollar’s strength against a basket of rivals, topped 108 on Friday, rising to its strongest level in a month.

See: US dollar on fire, cutting 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 by making them worth less in US dollars.

Cryptocurrencies are falling

Cryptocurrencies like bitcoin BTCUSD,
and ethereum ETHUSD,
has also recently traded almost in lockstep with stocks, particularly megacap technology stocks like Meta Platforms Inc. META,
and Netflix Inc. NFLX,
But crypto sold off sharply on Friday, leading some to wonder if stocks could be next.

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

See: “There is no reason to treat the crypto market differently than the rest of the capital markets just because it uses a different technology”: SEC Chief Gary Gensler

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

Valuation of stocks does not synchronize with the company’s earnings

Another reason to question the rise in shares is that there appears to be a link between valuations of shares and expectations of corporate earnings.

As Goldman pointed out, the price-to-earnings ratio of the S&P 500 has returned to 18.6 times forward earnings, from a low of 15.5 in mid-June. At the same time, expectations for corporate earnings from the same companies over the next 12 months have fallen from $238 to $230.

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

Goldman is hardly alone in worrying about rising stock values. 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 heading into 2023 could create a “valuation headwind” for stocks.

“We would say that tactical sales to additional strength are justified,” he said.

US stocks fell on Friday, with the S&P 500 SPX,
declining 55.26 points, or 1.3%, to 4,228.48, while the Nasdaq Composite COMP,
lost 260.13 points, or 2%, to 12,705.22. Dow Jones Industrial Average DJIA,
fell 292.30 points, or 0.9%, to 33,706.74.

Friday’s losses in stocks pushed all three major stock benchmarks into the red for the week, marking the first weekly drop for the S&P 500 and Nasdaq in a month.

The highlights of next week’s economic data calendar are expected to come on Friday, when Federal Reserve Chairman Jerome Powell is also scheduled to deliver his annual speech from the annual Kansas City Fed symposium in Jackson Hole, Wyo. Economists expect him to use the opportunity to emphasize the Fed’s commitment to fighting inflation.

See: Powell will tell Jackson Hole that recession will not stop the Fed’s fight against high inflation

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

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