Bond Yields Give Way to Earnings as Market Driver

The market experienced a tumultuous week, with stocks teetering on the edge of a meltdown due to surging bond yields. However, the Dow Jones Industrial Average managed to only drop 0.3%, while the S&P 500 index increased by 0.5% and the Nasdaq Composite gained 1.6%. Surprisingly, the Cboe Volatility index, also known as VIX, ended the week relatively flat at 17.3, despite reaching its highest level since May at 20.88 on Wednesday.

The main driver of this volatility was the skyrocketing 10-year Treasury yield, which reached as high as 4.89% during the week, significantly higher than its low of 3.23% in March. Concerns about an impending recession have dissipated, giving way to worries that the economy may be overheating. The Federal Reserve, following its September announcement to maintain higher interest rates for a longer duration, may need to take further action to ensure inflation returns to its target of 2%. These concerns reached their peak on Friday with the release of a robust jobs report. As a result, it seems that the stock market is ready to shift its focus away from bond yields as the primary driver of market performance.

Bond yields have indeed played a significant role thus far. Despite the S&P 500 experiencing a 7% decline since its peak in July, the "equity risk premium," which compares the index's earnings yield to the yield on the 10-year Treasury, remains at 0.8 percentage points. This suggests that the recent selloff was primarily driven by investors seeking higher yields from Treasuries rather than fundamental issues such as earnings power.

Earnings Season Kicks Off: Anticipating Potential Disappointment

It's that time of year again - earnings season is just getting started. We eagerly await the financial reports of major companies, hoping for positive surprises beyond the projected 0.05% increase in third-quarter profits. Interestingly enough, companies have managed to surpass expectations during the first and second quarters, raising hopes for an even stronger performance this time around.

However, the optimism surrounding this earnings season might be short-lived. With a notable increase in earnings estimates preceding the quarter, there is a risk of potential disappointment, which could trigger a downward trend in the market once again. As Ned Davis Research's chief U.S. strategist Ed Clissold notes, "A robust third-quarter earnings season may be needed to support a year-end rally."

Unfortunately, this desired robustness might not come to fruition. Seaport Research Partners' macro strategist, Victor Cossel, suggests that the economy typically experiences a delayed impact when interest rates rise. As a result, once the economy begins to falter, there is a possibility of underwhelming profits.

What if analysts are forced to revise their estimates downward? In such a scenario, the extent of the market downturn would depend on the magnitude of the cuts and whether key support levels can be maintained. Should the S&P 500 fail to stay above 4200 (as it did in the previous week), it could stumble down to approximately 4100. However, if the declines occur rapidly, momentum could drive the index even lower, potentially descending to around 3900, constituting an 8% downside, according to Katie Stockton, managing partner at Fairlead Strategies.

Naturally, a disappointing third-quarter earnings season has the potential to fuel such downside risks. All eyes will be on these reports, with investors hoping for positive outcomes that exceed expectations. Let's keep our fingers crossed that this season doesn't bring too much disappointment.