Market insights and analysis

By Jason Teed

The major U.S. stock market indexes took a breather from recent gains last week. The Dow Jones Industrial Average fell 1.11%, the Russell 2000 small-capitalization index dropped 1.21%, the S&P 500 Index lost 2.27%, and the NASDAQ Composite was down 2.85%.

Energy was the only sector to gain last week, rising 1.15%. Technology and Utilities were the worst-performing sectors, falling 4.14% and 4.66%, respectively. The lack of a clear pattern in the risk-on and risk-off sector losses suggests that the market sell-off was not due to a deterioration in market fundamentals, at least broadly speaking.

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Stocks

Last week, the S&P experienced its first 1% daily drop since May. Throughout 2023, the market has generally trended up, fueled by hopes that the Federal Reserve will be able to successfully control inflation without significantly damaging the economy. However, the world’s largest economy is experiencing an unprecedented blend of fiscal successes and challenges, leaving many investors struggling to make sense of the changing landscape.

Last week’s sell-off was largely due to Fitch Rating’s recent downgrade of the U.S. government’s credit rating. The decision was influenced by an unsettling trend of fiscal deterioration, mounting government debt, and waning confidence in the government’s ability to meet its obligations. This downgrade appears to have given investors a reason to take money off the table in the short term after recent runs in equity values. The last major downgrade of U.S. credit rating was by Standard & Poor’s in 2011, a decision that has not been reversed and which led to significant market volatility.

It’s essential, however, to place this downgrade into perspective. Standard & Poor’s downgrade was novel at the time, leaving investors scrambling to assess its ramifications. While current federal debt payments have risen, accounting for around 2% of GDP, they are significantly lower than in previous periods such as the 1980s and 1990s. So, although we’re seeing an uptick in debt burdens, the situation is far from the debt crises of decades past.

At the same time, other fiscal developments are promoting shifts in the financial landscape. Yields at the long end of the yield curve have risen, which is often linked with investor optimism about economic strength. This development can be attributed to several factors, including overall economic improvement and the Bank of Japan’s recent adjustments to its yield-management policy.

The labor market, a crucial determinant of both economic and stock performance, is sending mixed signals. Despite a cooling trend, the job market remains comparatively robust, suggesting resilience within the U.S. economy. Payrolls grew by 187,000 over the past month, slightly below expectations, but slack in the market remains near historic lows. While slower growth might typically trigger investor caution, the labor market’s current stability may offset such concerns.

Earnings news is also currently influencing the economic landscape. Around 71% of companies have exceeded revenue expectations. More importantly, there is a consistent trend of upward revisions in earnings guidance. This suggests increased corporate confidence in future profitability, which could further reinforce the stock market’s resilience.

The “soft landing” the Fed has been aiming for seems increasingly attainable, but this does not mean that the U.S. is out of the woods. Many high-profile economists disagree about where the U.S. economy, government debt, and the U.S. dollar are heading. For now, overall market sentiment appears largely optimistic about prospects for the latter part of the year.

Bonds

Treasury yields were mixed last week. Shorter-term maturities fell, with the largest losses observed in the two-year maturities. Longer-term maturities rose, with the largest gains occurring in 30-year rates. This resulted in a reduction in the steepness of the yield-curve inversion, though it remains heavily inverted. The rise in longer-term rates suggests the market is growing more optimistic about long-term economic growth than it has been recently.

Both term and credit yields rose last week, giving conflicting signals about bond market expectations of the economy. Overall, long-term Treasurys underperformed high-yield bonds, and longer-term bonds underperformed shorter-term bonds.

Gold

Spot gold fell for the week along with equities, losing 0.85%. This suggests that last week’s equity sell-off was not motivated by investors looking for a safe haven for their assets.

Despite enjoying some recent tailwinds, the metal is still off the highs it reached in May. Prospects are uncertain. Additional tailwinds may materialize as the Fed reaches the end of its monetary tightening cycle. Rising rates tend to hinder gold performance. As gold doesn’t offer income returns, it becomes less attractive when other assets have high yields. With rates no longer increasing, the metal may experience some upside movements.

Non-currency safe-haven assets, such as long-term Treasurys, were also down for the week.

Flexible Plan Investments (FPI) is the subadvisor to the only U.S. gold mutual fund, The Gold Bullion Strategy Fund (QGLDX), designed at its introduction 10 years ago to track the daily price changes in the precious metal.

The indicators

Our Political Seasonality Index was fully invested for the week. (Our QFC Political Seasonality Index is available post-login in our Weekly Performance Report section under the Domestic Tactical Equity category.) The very short-term-oriented QFC S&P Pattern Recognition strategy’s equity exposure varied last week. It began the week with short positions, changed to neutral on Wednesday’s close, moved to 1.5X long on Thursday’s close, and remained there to begin this week.

Our intermediate-term tactical strategies are mixed in exposure. The Volatility Adjusted NASDAQ (VAN) strategy began the week 200% long. It then changed to 180% long on Wednesday’s close, 140% on Thursday’s close, and 180% on Friday’s close. The Systematic Advantage (SA) strategy was very active, trading nearly every day of the week. Exposures for Monday through Friday, respectively, were 90%, 90%, 120%, 90%, and 30%.

Our Classic strategy was fully invested for the week. The strategy can trade as frequently as weekly.

Flexible Plan’s Growth and Inflation measure, one of our Market Regime Indicators, currently indicates an Ideal economic environment stage (meaning a declining inflation rate and positive quarterly GDP reading). Historically, an Ideal environment has occurred 28% of the time since 2003 and has been a positive regime state for equities, and bonds, but negative for gold. Equities tend to outpace bonds on an annualized return basis in an Ideal environment, albeit with higher risk.

Our S&P volatility regime is registering a Low and Falling reading, not having been affected much by last week’s market sell-off. This environment favors equities over gold and then bonds from an annualized return standpoint. The combination has occurred 37% of the time since 2003. It is a stage of relatively high risk-adjusted returns for equities but midlevel returns and high risk for gold.