Equity bulls aren’t giving up

US stocks rallied yesterday after the S&P 500 fell by almost 2.5% from its record high this month. Energy, financials, basic materials, and industrial sectors all gained by more than 1%, while Tech and consumer cyclical stocks also managed to advance 0.84% and 0.81% respectively. For every four stocks that gained only one declined, representing a broad rally, something which we have experienced only few times recently, and implies improving investors’ confidence.

Inflation expectations have been the biggest worry amongst investors, but the latest CPI release from the US seems to have supported views that high inflation will begin to go away soon. I’m not completely in the “transitory camp” yet, but most market participants are. If the markets are right on inflation and it proves to be transitory, the risk of surging bond yields diminishes, and keep stocks the only game in town.

However, stocks also need robust economic and corporate profit growth to sustain the momentum, and this is what investors should worry about in the upcoming weeks and months. The economic prospects are clearly deteriorating, thanks to the delta variant. Late last year, hopes were high that towards mid 2021 everything will return to normal. In fact, we are still far away from normal, especially in the US in which daily deaths due to covid are showing no sign of abating. The country averaged 1,805 new Covid-19 deaths each day over a week as of Tuesday according to John Hopkins, with new daily cases average above 150,000. Despite these depressing figures, investors are not overly worried, but if the third covid wave lasts longer, there is lot of risk that needs to be priced in equities.   

Expect volatility to increase over the upcoming days until those headwinds and concerns abate. Friday also brings the quadruple witching where stock options, stock index futures, and stock index options all expire, and that tends to increase the level of volatility.