Record S&P 500 Masks a Fear Trade That’s Gripping Stock Market

(Bloomberg) -- Surveying the recent stretch of records for the S&P 500 Index, you'd be tempted to think that when it comes to markets, everything is awesome. Inflation fears have eased, economic indicators are strengthening and the Federal Reserve remains accommodative.

But look past the sunshine and lollipops, and you'll find a growing sense of defensiveness.

Investors are taking risk off the table as the fast-spreading delta variant of the coronavirus causes fresh outbreaks in many parts of the world. Airline and cruise stocks are being dumped while there's a renewed embrace of the stay-at-home trade. Businesses' hiring woes have increased concerns over rising wages, prompting a pivot toward pricing power. Sectors seen as hardy growers, like technology, are back on top.

There are even indications that the S&P 500's 90% rally from the pandemic bottom could be due for a pause, since fewer stocks are participating in the latest leg up. This has helped put a halt to massive equity inflows and driven a sharp demand for government bonds.

“What the market is starting to recognize is that all the good news cannot be good in every single way,” Daniel Skelly, head of market research and strategy at Morgan Stanley Wealth Management, said in an interview on Bloomberg TV and Radio. “There is a realization that earnings revisions are starting to plateau and roll over.”

The S&P 500 advanced for a fifth week in six, closing above 4,300 for the first time in history. The tech-heavy Nasdaq 100 Index outperformed, rounding out seven straight weekly gains, the longest streak since November 2019. Economically sensitive shares lagged and the Russell 2000 of smaller companies fell.

The contrast between tech and small-caps is the latest example of investors quickly adjusting their positions in anticipation of stronger headwinds. In this playbook, safety is the name of the game.

Exchange-traded funds focusing on U.S. stocks lost almost $6 billion in the week through Thursday, a departure from the first few months of the year, when they lured more than $200 billion of fresh money, data compiled by Bloomberg show. Meanwhile, demand for safe havens spurred the second-highest monthly inflows to the iShares 20+ Year Treasury Bond ETF (ticker TLT).

Professional speculators also started to rein in risk. In the final days of June, hedge funds reduced their long positions while covering their shorts. Combined, their risk-off activity reached the highest level since late January, prime broker data compiled by Goldman Sachs Group Inc. show. Still, with net leverage sitting higher than 90% of the time over the past year, positioning is hardly bearish.

While the list of worries is long, there is no shortage of reasons to stay invested. Growth may be peaking, but corporate earnings are still expected to expand through at least 2023. Fed policy makers have shown a hawkish tilt, yet say they're a long way from raising interest rates.

To Liz Ann Sonders, Charles Schwab Corp.'s chief investment strategist, the market outlook remains murky.

“Did the pandemic pause the cycle that was in play in the economy and the market up until February last year, or did it end one cycle and start a new one?” Sonders said in an interview on Bloomberg TV. “We'll start to get answers to that in the next few months when we move past the base effects in terms of economic data and inflation data.”

Investors are not waiting to find out. With inflation rising, companies seen as better equipped to pass on costs to customers without hurting their business are in vogue. Their stocks, as tracked by Goldman, last month beat a cohort with low pricing power by the most since March 2020, the start of this bull market.

Meanwhile, brooding over a potential economic slowdown sparked a rotation back to growth stocks out of value, a style dominated by cyclical shares. The Russell 1000 Growth Index outperformed its value counterpart in June by the most in two decades.

The reopening trade that's frolicked since November's vaccine rollout has been quieted as the delta variant spreads from Europe to Asia. A Goldman basket of stocks poised to benefit from a return to normal economic activity just suffered its worst month since last July relative to the stay-at-home basket.

“People are really nervous about anything that could see a resurgence in cases or a return to some of the shutdowns,” said Chris Gaffney, president of world markets at TIAA Bank. “It's just a reminder that this Covid is still out there and could raise its head again.”

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