U.S. equities moved higher in a classic “gap-and-grind” pattern driven by the largest squeeze on the most shorted stocks in four years.
All of this is a continuation of the response to the weaker-than-expected September payroll report on Friday — just 142,000 jobs were created last month, well below the lowest analyst estimate and well under the consensus expectation of 203,000 — which bolstered hopes that the Federal Reserve’s near-zero interest rate policy will continue through the early part of 2016.
In the end, the Dow Jones Industrial Average went up 1.9%, the S&P 500 gained 1.8%, the Nasdaq Composite increased 1.6% and the Russell 2000 finished the day 2.5% higher. Treasury bonds weakened while crude oil gained 1.9% to close at $46.42.
Industrial stocks led the way for a gain of 3%, while healthcare were the laggards, rising just 0.3%. Twitter Inc. (NYSE:TWTR) gained 7% after the company confirmed the appointment of Jack Dorsey as CEO. Analyst upgrades from Axiom Capital and Topeka Capital Markets helped as well.
General Electric Company (NYSE:GE) gained 5.3% after it was revealed activist fund Trian had acquired a $2.5 billion position in the stock since May and is looking for reform measures such as cost cutting and issuing debt to fund share repurchases.
Futures market pricing puts the odds of a rate hike at the Fed’s October meeting at just 2% while the odds of a December hike have fallen to 29% from more than 40% early last week. Goldman Sachs analysts highlighted that futures market odds surrounding a 2017 start to the rate hike cycle moved up significantly.
Yet, there is still a significant risk the Fed decides to hike rates this year anyway.
After the jobs report, St. Louis Fed President James Bullard downplayed the result and reiterated that now was the time to start the policy normalization process. He added that the mix of employment and inflation is as good as it’s ever been, emphasizing the trend in job creation rather than a single soft report.
Fed vice-chairman Stanley Fischer chimed in with a focus on the fact there are “obvious” bubbles in the economy and that the Fed could go after them with higher interest rates at certain times.
And for all the excitement in stocks and commodities surrounding hopes of a continuation of the Fed’s easy money policy that’s been in place since 2008, the bond market is much less excited.
This is why bonds matter: As long as bond prices are weak, the flow of debt-funded corporate buybacks (one of the main sources of stock market buying demand) will be under threat. More simply: Unless bonds perk up too, this stock market rebound will prove short lived.
The Barclays High Yield Bond ETF (NYSEARCA:JNK) is up 1.7% from its Friday low, but is still down more than 7.3% from its May high. That’s enough to wipe away more than a year-and-a-half of the fund’s dividend payouts.
In higher-rated investment-grade corporate bonds, spreads over U.S. Treasury bonds have widened to two-year highs, thereby raising the cost of the type of buyback financing Trian is looking for GE to pursue.
The cancer of bond market weakness, which started in coal two years ago before moving to overleveraged energy plays, is now infecting a growing swath of the market, taking down names in retail and semiconductors according to research by Bank of America Merrill Lynch.
They’ve started to wonder whether a turn in the credit cycle is already underway before the Fed has lifted a finger on short-term interest rates. Corporate earnings are certainly under pressure: According to Factset data, S&P 500 earnings are set to decline 4.5% in the third quarter vs. last year, and are on track to report the first back-to-back decline in quarterly earnings since 2009. We’ll know more when the Q3 reporting season kicks off on Thursday with Alcoa Inc. (NYSE:AA).
Barclays Capital highlights in the chart above that the current drop in profit margins rarely happens outside of recessions.
The slowing of corporate purchases would come at a time of stock market vulerability. The NYSE Composite tested down to its October 2013 levels last week, and has twice threatened a move below 200-week moving average in August and again in September — a level that hasn’t been breached in a big way since 2011.
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