Tech earnings could determine whether sell-off is routine pullback or leadership crisis for stocks

The Wall Street Bull (The Charging Bull) is seen during Covid-19 pandemic in New York, on May 26, 2020.

Tayfun Coskun | Anadolu Agency via Getty Images

The stock market debate lately has taken place largely from the extremes.

The believers are calling the powerful rebound from the Covid-shock lows a brand-new bull market, with a close resemblance to the 2009 post-recession bottom in terms of magnitude and velocity against a brimming reservoir of pessimists. Equity gains were well above average for a decade thereafter.

Market skeptics look at the same market and see the year 2000 — one of the worst entry points for stocks in history — with extreme concentration of value in a few expensive tech stocks and a rush of novice at-home speculators whipping long-shot stocks into a froth.

This polarized shouting match overlooks a vast middle ground, in which the market is sorting through a range of plausible scenarios, alternately cheered and chastened by a fitful recovery, supported by generous credit conditions while restrained by aggressive valuations on the S&P 500's biggest sectors.

The polarized "Baby Bull" versus "Big Bubble" argument also makes each rally and pullback seem a decisive moment of truth rather than a normal ebb and flow.

And so, the shakeout over the past two weeks in the leading mega-cap tech stocks, with sell-the-news responses to earnings from Netflix, Microsoft and Tesla, is cast by some as a consequential regime change and leadership crisis for the market, when it remains a fairly routine pullback for now.

The Nasdaq is a bit more than 4% off its record high, and last week slipped back merely to its 21-day moving average — a widely watched short-term trend line that the index touched twice before since June.

Until the galloping glamour group atop the Nasdaq breaks stride more decisively, it's hard to call this a decisive comeuppance for Big Tech. Of course, it would also be quite routine if the Nasdaq gave back a bit more.

Unusual upside for months

Bull markets pull back to a 50-day average in the normal course of things, which in this case would mean another 4%-5% downside and a breach of the 10,000 level first reached in early June. Given the heightened emotions around this part of the market, such a retreat probably wouldn't be treated as the routine matter it is.

Admittedly, the way to make a 4% dip over two weeks seem like a big deal is to show extreme and unusual upside persistence for months, which is what the Nasdaq has done.

Friday ended the Nasdaq's longest-ever streak without back-to-back daily declines at 49 sessions, one longer than the prior record from 1979. Bespoke Investment Group notes that following the 10 longest such streaks for Nasdaq over its near-50-year history, performance following the end of these runs has on average been a bit stronger than average returns over periods from one week to a year.

That said, BTIG strategist Julian Emanuel points out the Nasdaq-100 has outperformed the S&P 500 each of the nine months through June — and the only time it did so for longer was right into the March 2000 market peak. He argues July will see the end of this streak, with record-low short interest in tech suggesting little dry powder, tepid earnings reactions and the common struggle with big round index numbers (10,000).

The selling that met marquee tech earnings reports so far seemed to show these stocks do better when viewed as abstract claims on decades of cash flows and competitive dominance, rather than companies that need to show unambiguous progress toward those things every three months.

Big tech earnings ahead

Maybe this is a preview for the coming week, when Amazon, Apple and Facebook report results. Yet earnings season often goes in phases, with the first batch of reports resetting trader expectations for the next. These three stocks, perhaps helpfully, have all backed off between 7% and 10% from their recent highs entering their reporting week.

So far, the broader market has absorbed the softening of the growth giants without much net damage. It's quite a mathematical challenge for the S&P to offset any sustained weakness in the Big Five of the Nasdaq, (Apple, Microsoft, Amazon, Alphabet and Facebook), which peaked above 22% of the S&P's market cap this month. It means, for instance, that if Microsoft slips 1%, JPMorgan needs to gain 5% to hold the S&P harmless.

A more pronounced rotation toward more cyclically geared stocks probably requires a surer sense that the Sun Belt Covid-case surge has peaked and that the next fiscal-support package being hashed out in Washington will be adequate to cushion the consumer. Would this be enough to lift Treasury yields from multimonth lows, something that in that past has given clearance for value and smaller stocks to make progress?

Another market dynamic that one could call an extreme version of a typical pattern: Stocks rebounded hard in advance of an upturn in earnings forecasts from depressed levels. Here's the S&P 500 against forward 12-month consensus profits, as tracked by FactSet.

Clearly the upturn in stocks has been more dramatic than the gentle, modest climb in expected earnings, and the gap between the lines means equities are more richly valued than they've been in a while.

It's less credible than it's been in months to say this stock rally is "hated." The number of upside bets via call options bought compared to puts is running near a nine-year high. Corporate-insider selling has ramped to more than a one-year high. Seasonal forces tend to turn a bit tougher in August.

The makings of a range-bound, two-way market, perhaps?

Bank of America's Michael Hartnett, correctly bullish in recent months, has been suggesting for a while that above 3,250 for the S&P 500 is an area to take profits. But pullbacks, he says, are still opportunities to add to stocks.

"Positioning is not uber-bullish, policy is not tightening; this is not the big top. But world equity market cap has round-tripped from $89 trillion to $62 trillion back to $87 trillion. Hard to see financial conditions getting incrementally easier in July/Aug period of 'peak policy' stimulus. Summer dip in risk assets (e.g. SPX to 3050) likely."

Which would be about a 5% drop from here and, all things considered, pretty routine.

Correction: Julian Emanuel is a strategist at BTIG. An earlier version misspelled his name.

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