What’s needed for stocks to rally is capitulation, but that could come from unexpected sources, strategist says

But a 10-year Treasury yield
BX:TMUBMUSD10Y
surging to 4.25% for the first time since the great financial crisis is a looming reminder that to do so would be fighting the Fed.

As Tom Lee, head of research at Fundstrat says after conversations with clients this week: “The main question is why should any investor expect equity prices to stage any meaningful gain from here, in the midst of a Fed tightening cycle and in the midst of great uncertainty around the Russia-Ukraine war, increasing stress in financial markets (UK issue tabled for now) and in the midst of massive gloom of CEOs and Americans and investors.”

To make them feel better the market needs a cathartic blowout. A last frenzy of selling that exhausts the bears and sets the stage for a sustainable rally. In other words, yes: capitulation!

The problem, says Lee, is that investors reckon that the path of least resistance in the market is for equities to capitulate. A scenario where the CBOE Vix index
VIX,
the gauge of expected S&P 500 volatility, spikes above 40, stocks drop another 20% and there is some sort of financial accident, like a hedge fund imploding.

“But this is not the only ‘capitulation’ that could lay ahead,” he argues in his latest note. “There are other forms of ‘capitulations’ that could similarly boost investor confidence, in turn, fueling a firm footing for equities.”

And he has a list. First, “Inflation ‘hard data’ could capitulate, syncing up with the ‘soft data’ which have been showing growing signs of falling inflation.”

This in turn could cause the Fed reaction function to capitulate and shift the central bank from hiking by 75 basis point after every strong consumer price index report.

Next, another type of Fed capitulation is if it shifts “to a more ‘inflation tolerance’ view, acknowledging part of core inflation reflects supply chain tightness (transportation services) and recognizing severe lags in data such as shelter/rent CPI component”.

How about the tight labor market finally capitulating, says Lee, with falling job openings and less wage growth pressures (though he accepts that currently strong jobless claims data don’t presently support this scenario).

Also, it may be possible that given the surge in yields of late, fixed income bulls start finding the bond market increasingly attractive even before data turns or the Fed signals pivot. “Interest rates could stop powering higher,” a “capitulate on yield” if you will.

Finally, investment sentiment has largely already capitulated. “The BofA fund manager survey shows that institutional investors most underweight equities in more than 20 years,” Lee notes.

He summarizes: “There are multiple pathways for markets to move higher. And while investors are mostly expecting equity markets to capitulate. There are other capitulations that could drive asset prices higher.”

Markets

Benchmark 10-year Treasury yields
BX:TMUBMUSD10Y
rose 4.3 basis points to 4.276%, their highest since 2008, as investors priced in stubborn inflation and more Federal Reserve rate hikes. The move up in yields hit S&P 500 futures
ES00,
down 0.7% to 3650 and lifted the dollar index
DXY,
up 0.6% to 113.51. Worries about slowing demand pushed WTI crude futures
CL
down 0.3% to $84.25 a barrel.

The buzz

Snap shares
SNAP
are slumping more than 25% to trade at their lowest since early 2019 after the messaging app, following Thursday’s close, announced widening losses and said revenue growth would slow.

Twitter shares
TWTR
fell more than 8% to around $48 a share in premarket action after reports Elon Musk said he would cut 75% of the workforce. Musk is supposed to be paying $54.20 a share so that he could carry out any such threat, so it’s thought the slide has more to do with reports the U.S. is considering national security reviews for some of Musk’s ventures.

The U.S. third quarter earnings season continues, with Verizon
VZ,
American Express
AXP,
Seagate
STX,
and Schlumberger
SLB
 among those presenting their figures.

The dollar moved above 150 yen
USDJPY
as the Bank of Japan’s determination to maintain its loose monetary policy pushed the yield spread between 10-year U.S. and Japanese government bonds
BX:TMBMKJP-10Y
above 4%.

Weeks of political and financial market turmoil, with inflation back to a 40-year high of 10.1%, has pushed U.K. consumer sentiment to its worst in half a century. Little surprise then that the country’s retail sales fell 1.4% in September, much worse than the expected 0.5% decline.

Gilts
BX:TMBMKGB-10Y
and the pound
GBPUSD
were in retreat after the sales data and ahead of a weekend of jostling to be the next leader of the governing Conservative Party, and thus the new U.K. Prime Minister.

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The chart

“Equity investors seem sharply focused on timing the peak in inflation and central bank hawkishness. And with economic data remaining historically volatile and difficult to forecast, the importance of economic data releases has grown to levels not seen in years, if ever,” says the global equity derivatives team at Bank of America.

As the chart below shows, this has left the stock market becoming increasingly reactive to economic data surprises. “The last two quarters saw the most ‘excess’ S&P futures intraday realized volatility around key data prints since at least 2018, and the last three quarters have been among the five highest,” says BofA.

Top tickers

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