Yikes or YOLO?

Yesterday, the bond investors said “yikes!” while tech stock traders answered “YOLO.”  With 10-year rates rising over 9 basis points yesterday and over 30 bp since the month began, concerns in the fixed income arena continue to mount – especially ahead of Chair Powell’s Friday address to the annual Jackson Hole conference.  Meanwhile, rampant enthusiasm ahead of Nvidia’s (NVDA) earnings and a significant buy-the-dip rally in Tesla (TSLA) led the NASDAQ 100 (NDX) over 1.5% higher.  

In my experience, when bonds and stocks fundamentally disagree, it is the bond market who is more often proved correct. 

I first learned this lesson when I was part of the Salomon Brothers training class.  We needed to rotate through different sales and trading desks.  The bond floor was generally glum because rates tended to rise inexorably for months.  At the same time, the equity floor was robust because prices seemingly rose each day.  In August of 1987, the mood began to change, particularly after a major state pension fund executed a huge asset allocation from stocks into bonds, and of course it came to a violent end two months later. 

Of course, not all disagreements between stocks and bonds end that violently.  It is also important to recognize that the 1987 divergence occurred for months.  The timing of when different market sectors resume an agreement is quite uncertain.  But it is probably no coincidence that August-October tends to be a tricky period for equity investors.

In an era when we’re online all the time, it can be discombobulating to disconnect, even for a few hours.  After a few days off enjoying the sights and shows of Edinburgh, I boarded (a delayed) flight home, and turned off my phone rather than hooking into the airline’s Wi-Fi.  It was nice to sleep and read a book[i] without concerning myself about the market for a few hours.

To say that I was surprised by the ferocity of yesterday’s rally is an understatement.  I checked the markets before boarding and thought it was curious that stocks were up even as bond yields continued their ascent.  It seemed reasonable for stocks to bounce after a difficult week, and they had gotten somewhat oversold on a short-term basis, but higher rates appeared to be a high hurdle.  When I landed, markets had closed, and the ensuing move in NDX was truly unexpected.

I dug deeper into the intraday activity and recognized the unique – ok not-so-unique – character of yesterday’s rally.  The “Magnificent Seven” rode to the market’s rescue once again.  Declining stocks outpaced advancers on both the NYSE and Nasdaq, which was more consistent with the backdrop of rising rates.  Remember, if stocks and bonds can tell a different story for months, they can certainly diverge for a day or two.

One thing to keep in mind is that even though the Cboe Volatility Index (VIX) and similar measures remain well above their recent lows, they are still relatively low on a longer-term basis, as shown by the chart below.  That said, we have recently seen a pattern of both higher lows and highs, which could indicate an incipient uptrend:

VIX 6-Months, Daily Bars

Source: Interactive Brokers

What we do see is that VIX has climbed back to the low end of its April-May trading range.  The worst of the banking crisis was behind us, partly thanks to $300 billion of lending by the Federal Reserve, which undid much of the prior few months’ quantitative tightening.  That was the prior quarter’s earnings season.  Broadly positive results and a heavy dose of enthusiasm about artificial intelligence engendered by remarkably positive guidance from NVDA then gave the market another leg higher and volatility another leg lower. 

Since its last earnings report, we have seen NVDA rise more than 50%.  It is up about 15% since two Fridays ago.  There is certainly a high degree of enthusiasm priced into its next report, due after tomorrow’s close.  We also face the prospect of a highly consequential speech by the Fed Chair on Friday.  Either or both can swing markets dramatically.  We are unlikely to see whether the bond market’s “yikes” or the AI enthusiasts’ “YOLO” fully wins out this week, but we are likely to get important clues about the ultimate victor.  In the meantime, it may behoove those who are uncertain about the outcome to seek volatility protection at relatively modest prices.

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[i] Trainspotting, by Irvine Welsh, proved an appropriate choice, especially after seeing a live version at the Edinburgh Fringe Festival