7. The Federal Reserve made it clear that rates will be zero-bound for the foreseeable future. At last week’s policy meeting, the central bank indicated it isn’t planning to raise rates through at least 2023.
8. Negative real interest rates have been propping up stock markets. Interest rates are at or near record lows and inflation expectations are starting to creep higher, forcing real rates further into negative territory. Rising interest rates and/or inflation could eventually present a headwind for stocks.
9. Internal stock market dynamics are shifting. The equal-weighted S&P 500 is on pace for its best month relative to the cap-weighted S&P 500 since 2009, reflecting the selloff in mega-cap stocks and broadening participation.2 We think this shift could continue.
10. Many financial markets have been consolidating recent trends. Credit spreads have been tightening before pausing in recent weeks, while gold prices and the U.S. dollar are consolidating their respective upward and downward price trends. These technical indicators also suggest we could see additional consolidation and rotation within U.S. equities.
Stock Selection Looks Increasingly Important
The recent downside in mega-cap tech stocks has yet to affect other areas of the market. Investors appear convinced that ultra-supportive monetary policy will keep stock prices afloat, despite a failure to pass a new fiscal stimulus package and an economic backdrop that increasingly points to decelerating growth.
Regarding that latter point, the rebound has been underwhelming after an initial sharp bounce in early summer. Persistently high coronavirus infection rates are making it difficult to reopen schools and businesses, keeping economic activity depressed. Although governments and policymakers are loathe to return to mandated lockdowns, individuals are clearly not comfortable returning to pre-pandemic activities without a vaccine or notable medical breakthrough. Inflation could also pick up in the coming years, as disinflationary pressures start to fade and we expect an uptick in inflation around the world at some point.
This leads us to have a cautious near-term outlook toward stocks, focusing on areas of the market that still seem overvalued. Market action over the past few weeks reflects a shift away from growth and momentum (and particularly that handful of mega-cap tech stocks) and toward value and cyclicals. In other words, we’re seeing less of a broad-based correction and more of a rotation correction.
We think this trend could still have legs and markets remain overbought. In the weeks ahead, we could see near-term bounces, additional volatility in both directions and ongoing internal market shifts. As such, we think investors should focus on selectivity, rotating out of overvalued areas and into more attractive areas that could be oversold and still offer value and positive relative earnings growth prospects.
Robert C. Doll is senior portfolio manager and chief equity strategist at Nuveen.