Higher rates and Washington dysfunction are combining to push the market lower

This is a very tricky moment for the markets. The market is in the middle of another rise in interest rates, which is causing traders and investors to move a lot of stocks around.

Political dysfunction from Washington is not helping, particularly when there are potential tax changes in the air.

“[Treasury Secretary Janet] Yellen said she is in favor of eliminating the stepped-up cost basis,” Alec Young, chief investment officer at Tactical Alpha, told me. “There is a lot of gains locked into those tech stocks, particularly from wealthy individuals. Throw in the inability to raise the debt ceiling, and you have a lot of uncertainty coming out of Washington.”

Throw in higher rates, and money is moving out of technology (growth) and into value (energy, banks).

Big Tech
(since 9/16 close)
Microsoft: down 6.7%
Apple: down 4.2%
NVIDIA: down 6.9%
Micron: down 1.9%

Energy stocks are rallying as oil spikes over $75 (highest since 2014) on higher global demand and tighter supplies:

Energy stocks
(since 9/20 close)
Cabot Oil & Gas up 38%
EOG up 21%
APA Corp. up 19%
Devon up 18%
ExxonMobil up 9%

The problem is that a large percentage of the investing public is invested not in stocks, but in indexes. More than $7 trillion is directly indexed to the S&P 500 (about 17% of the $38 trillion value of the total S&P) but an additional $7 trillion is benchmarked against it.

But the composition of the S&P 500 is not friendly to a move down in tech stocks.

About 40% of the S&P 500 are tech stocks (28% in the technology sector, another 11% in communication services, and a smattering of tech-related names like Amazon in consumer discretionary).

Energy is an almost insignificant weighting:

S&P 500: sector weightings
Technology 28%
Communication Services 11%
Health Care 13%
Financials 11%
Consumer Discretionary 12%
Industrials 8%
Energy 3%

As investors rotate from tech-related stocks into energy, they are rotating from sectors that are 40% of the S&P into a sector that is 3% of the S&P (energy).

“Those energy stocks are now dramatically overbought. They are not that big, and they have made their move,” Young said.

The only reason the S&P is not moving down more is because of the two-week rally in banks, which are now approaching overbought territory:

Big banks
(since 9/20 close)
JP Morgan: up 9.4%
Goldman Sachs: up 4.7%
Citigroup: up 7.3%
PNC: up 8.7%

But even big banks have stopped moving up today. “If the financials can’t lead with rates rising, that is a bit worrisome,” Jay Woods, chief market strategist at DriveWealth, told me.

Industrials and materials, which investors had hoped would continue to rally as the global economy recovers, have instead drifted lower as China has continued to experience a slowdown related to the delta variant:

Industrials/materials this month
Illinois Tool Works down 7%
Dover down 8%
Caterpillar down 5%
Freeport-McMoran down 7%
Dow Inc down 4%

At the same time, consumer staples have also had a tougher time on supply chain issues and pricing power:

Consumer staples this month
Coca-Cola down 6%
Walmart down 5%
Kimberly-Clark down 4%
Colgate-Palmolive down 3%

Put it all together: Higher rates are creating more losers than winners.

Jonathan Corpina, senior managing partner at Meridian Equity Partners and a staple on the NYSE floor, is urging clients to stay calm.

“You have to keep this in perspective,” Corpina told me. “The S&P is still up 16% for the year, so far it’s less than 5% off the high. That is hardly a correction.”

Major indexes
(% off 52-wk highs)
Nasdaq 100 5.5%
Russell 2000 4.6%
S&P 500 3.7%

Corpina is telling his clients that he is not seeing any panic selling yet, and to take a deep breath.

“We are approaching the end of the quarter, and most traders still have returns of 2% to 4% for the quarter,” he said. “That is pretty good considering all the variables we have had to deal with, from the delta variant to China to higher rates.”