According to One Strategist, Here Are the Biggest Threats to the Bull Market

U.S. stocks declined for the third consecutive day on Wednesday as Treasury yields continued to rise. Earlier in the week, analysts from brokerage Strategas noted that equities often experience consolidation after reaching three-month highs in real yields. On Wednesday, the yield on the 10-year Treasury inflation-protected securities (TIPS) hit 1.93%, marking its highest level in nearly three months.

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Although consolidation in the stock market isn’t necessarily a bad development, especially with the S&P 500 up by 22% this year, the larger concern remains whether the bull market can be sustained in the longer term.

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Dhaval Joshi, chief strategist at BCA Research’s Counterpoint, highlighted Japan as a significant risk to the U.S. bull market. This concern calls to mind the market volatility in August when U.S. stocks, particularly in the technology sector, took a hit as the yen surged. At the time, fears arose about the possible end of the carry trade in the currency market, but those concerns have since dissipated. The U.S. dollar has gained 9% since hitting its mid-September lows, and the Nasdaq 100 ETF has rebounded, climbing 12% since August 5.

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Joshi pointed out that Japan’s inflation-adjusted policy interest rate is currently at negative 2.3%, creating a wide gap of 5.4% between Japan’s rate and that of the U.S. Since 2022, Japan’s real rate differential with the U.S. has fallen by 12 percentage points. He described this shift in real policy interest rate differentials between two major economies as "unprecedented," given the magnitude and speed of the change.

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Joshi explained that Japan’s deeply negative real interest rates have fueled what he terms a bubble in AI stocks. He emphasized the strong correlation between U.S. technology stock valuations and the exchange rate between the U.S. dollar and the Japanese yen. Investors might recall the market events of late July and early August, which were driven by a hawkish statement from the Bank of Japan and a weak U.S. jobs report. More recently, following the release of a stronger-than-expected U.S. jobs report on October 4, Joshi observed a paradoxical trend in the markets.

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As expectations for U.S. rate cuts diminished, U.S. bond prices fell. However, U.S. tech valuations, instead of deflating, rebounded. Joshi explained that this occurred because the real interest rate differential between Japan and the U.S. grew more negative, sparking renewed inflows into U.S. tech stocks funded by yen-denominated borrowing. This pattern mirrored the events that followed the August 2 jobs report, where Japan’s real rates compared to the U.S. became even more negative, driving further investment into U.S. technology stocks.

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Based on this, Joshi drew three key conclusions. First, if the yen’s deeply negative real rates compared to the U.S. are unsustainable, then so is the continued weakness of the yen itself. Second, taking a long position on the yen could serve as an effective hedge against potential weakness in U.S. tech stocks. Third, and perhaps most crucially, the causal relationship could work in either direction. On the one hand, higher real rates in Japan relative to the U.S. could depress U.S. stock valuations. On the other hand, a sharp drop in enthusiasm around artificial intelligence could unwind the yen-funded investments in U.S. tech, which would likely lead to an appreciation of the Japanese currency.

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Joshi also advised investors to consider overweighting U.S. small-cap stocks over U.S. tech stocks, indicating that small caps might present a better opportunity in the current market environment.

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On Thursday morning, futures contracts for major stock indices were on the rise, with the S&P 500 and Nasdaq futures posting gains. The S&P 500 futures contract (ES00) increased by 0.27%, while Nasdaq futures (NQ00) were up 0.72%. However, Dow futures (YM00) lagged behind, dragged down by a 100-point headwind from IBM and, to a lesser extent, Boeing. In other markets, gold prices rose slightly, while U.S. Treasury yields fell.

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The ongoing rise in Treasury yields has continued to weigh on the stock market, as higher yields make bonds more attractive relative to equities. However, the fall in Treasury yields on Thursday, along with the rise in gold, suggests a temporary shift in sentiment as investors reassess the potential for future interest rate cuts and other macroeconomic factors.

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In conclusion, while U.S. stocks have experienced a brief period of consolidation, driven by rising Treasury yields, the future of the bull market remains uncertain. Dhaval Joshi’s analysis underscores the potential impact of Japan’s deeply negative real rates on U.S. tech stocks and the broader market. As investors navigate these dynamics, hedging strategies and diversification into small caps may provide some protection against the risks posed by global monetary policies and fluctuating currency markets.

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