Here are 5 reasons why a rally in stocks could be about to turn into a bear market.

Here are 5 reasons why a rally in stocks could be about to turn into a bear market.

Some market gurus are starting to worry that Wall Street’s summer rally may be starting to fizzle out after stocks tumbled from oversold to overbought.

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

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

To support that view, he pointed out a handful of reasons why Friday’s equities slump could continue into the next week, and possibly longer — even if he remains bullish on equities over a longer time horizon.

Defensive sectors are back in fashion

The cyclical sectors outperformed, with stocks rising in July and early August. But that trend appeared to have come to an end this week, with defensive sectors regaining the lead.

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

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

On the other hand, the two sectors that presented the worst performances were the cyclical sectors. communication materials and services. The XLB Selected Materials Sector SPDR fund,
-1.84%
fell 2.4% on the week, while the XLC communications services selected sector SPDR fund,
-1.62%
fell 3.1%.

Bond yields are rising

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

Higher Treasury yields can pose a problem for equities because they make bonds a more attractive investment by comparison. Stocks and bonds often moved in unison at the start of the year as expectations of tighter monetary policy from the Federal Reserve rattled both assets.

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

The yield on the TMUBMUSD10Y 10-year Treasury bill,
2.973%
has increased 35 basis points since Aug. 1, and is 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 lower bond prices.

To see: Fed’s Bullard says leaning toward supporting 0.75 percentage point rise in September

so is the dollar

Rising Treasury yields and lower inflation helped lift the US dollar, creating another potential headwind for equities. The ICE US Dollar Index DXY,
+0.58%,
an indicator of the dollar’s strength against a basket of rivals, it topped 108 on Friday, rising to its strongest level in a month.

To see: US Dollar Is On Fire And Cutting Key Technical Levels ‘Like A Hot Knife In Butter’

A strong dollar is often 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,
+2.99%
and ethereum ETHUSD,
+6.08%
have also lately traded almost in tandem with equities, particularly megacap tech stocks like Meta Platforms Inc. GOAL,
-3.84%
and Netflix Inc. NFLX,
-1.64%.
But cryptocurrencies sold sharply on Friday, leading some to wonder if stocks could be next.

“Another sign of a market pause is weakness in cryptocurrencies. It’s a clear sign of a risky trend in the market,” Goldman said.

To see: ‘There is no reason to treat the cryptocurrency market differently from the rest of the capital markets just because it uses different technology’: Gary Gensler, head of the SEC

Bitcoin is down around 9.5% on Friday, while Ethereum, the second most popular cryptocurrency, is down around 10%, according to CoinDesk.

Stock valuations are out of sync with corporate earnings

Another reason to question the rally 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-earnings ratio has rebounded to 18.6 times future earnings from a low of 15.5 in mid-June. At the same time, expectations of corporate earnings for these same companies over the next 12 months have dropped from $238 to $230.

“Stocks are rising on estimates of falling earnings,” Goldman said.

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

“We would say that selling tactically for more strength is justified,” he said.

US equities 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%
dropped 260.13 points, or 2%, to 12,705.22. The Dow Jones Industrial Average DJIA,
-0.86%
dropped 292.30 points, or 0.9%, to 33,706.74.

Friday’s losses in equities sent all three major equity 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 due on Friday, when Federal Reserve Chairman Jerome Powell is also due to deliver his annual speech at the Kansas City Fed’s annual symposium in Jackson Hole, Wyo. emphasize the Fed’s commitment to fighting inflation.

To see: Powell to tell Jackson Hole the recession won’t 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 Spending Index, the Fed’s preferred gauge of price pressure. The closely watched University of Michigan opinion poll, which includes readings of consumer inflation expectations, is also on the calendar for Friday.

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