Stocks Are Back on Their Biggest Fault Line

The roaring growth-stock trade that’s been powering the S&P 500 since early summer looks vulnerable. The Nasdaq is slowing even as yields remain contained the past two weeks, and the price/earnings ratio of the Nasdaq compared to the Russell 2000 (normalized for profitable companies) is back at the highest level since September 2020 (see below).

Last fall may seem like ages ago, but it was an important moment for markets. Traders may recall the S&P 500 dropped 10% in just a few days, one of the sharpest corrections ever recorded. It also marked the peak for the forward P/E ratio of the Nasdaq-100 and S&P 500, which have been downtrending since.

A big thematic investing rotation took place from the fall of last year through the first quarter, as a combination of stimulus money and optimism around vaccines kept consumers spending and traveling despite a heinous winter COVID surge. As yields surged in the first quarter of 2021, there was enough momentum behind the reflation trade that it snapped off what many thought would be an unstoppable rally in expensive, high-growth tech names led by Tesla and embodied by Ark Invest's flagship growth fund. The schism between growth and value at that juncture created some sharp but short-lived volatility, as the rotation into cyclical stocks didn't get too far as Delta sent COVID cases climbing and economic data started missing expectations amid the backdrop of a Federal Reserve preparing for tapering.

Today, the question is whether there's appetite for such a rotation again if tech stalls out. To some degree it looks like it. The 10-year yield -- up until Tuesday's CPI print -- was grinding higher off its summer lows, and travel stocks have held steady since June. COVID cases are slowing in the summer hot spots, and the Fed has outlined a plan to slow down bond-buying without stepping on the toes of the economy. All that looks like a reasonable recipe for higher yields and rotation.

If it doesn't happen, it likely means COVID is eluding our control again, or traders have run out of free cash to deploy into the market. I'm more worried about the latter, as the rate of new money supply in the economy peaked earlier this year and it's not clear when the next round of stimulus is coming from D.C. Mega-cap tech stocks are doing an abnormal amount of legwork again, and the number of companies making new highs has been declining since February. Anyone who bought into the high-growth ARKK-style companies in the first quarter is still underwater as the bear market in sectors like electric vehicles persists. Not to mention that inflation has chewed into consumer cash flow as well this summer.

Yes, this may sound familiar -- it's basically the bear case I outlined in April. My view is that the summer Covid surge was a net-positive force for the stock market as it allowed the Fed to remain vague about its tapering timeline and revived the big-tech quarantine trade. If case curves go back down from here, the market is exposed again to a combination of potentially problematic rotation and withdrawal by central banks.

The Nasdaq looks untenably expensive again. Apple's expecting little to no earnings growth from here. If the mega-cap tech melt-up from this summer cools, stock bulls are going to need some seriously heavy lifting from reopening trades to sustain the market at new highs. There's good fundamental reason to think those businesses are due for a bounce, but the technicals do not look encouraging.

The market does not have a good record of crossing the fault line between secular tech and cyclical themes smoothly. Expect tremors.