The apparent boom in US stocks cannot hide internal fatigue! The S&P 500 is less than 2% from its all-time high, but the small-cap, banking and utilities sectors have suffered a severe setback

The Zhitong Finance App learned that as the yield on US 10-year treasury bonds once rose to 5.34%, a record high since 2002, Wall Street is fiercely discussing when the sell-off in the bond market will actually impact the seemingly strong US stock market. However, judging from the internal performance of the market, the pressure brought about by high interest rates is already evident.

Although the S&P 500 is still less than 2% from its all-time high, various sectors such as small-cap stocks, bank stocks, utility stocks, and high-risk technology stocks are already clearly under pressure. Meanwhile, weighted indices such as the S&P 500 are facing a seventh week of continuous decline, highlighting that the current rise in US stocks is increasingly dependent on a few large technology stocks.

Dan Suzuki, a global investment strategist at iCapital, said that currently most sectors of US stocks have fallen at least 5% from their respective highs, and some sectors have even declined by more than 15%. He believes that this is largely related to rising interest rates and the resulting tightening of the financial environment.

Currently, US stocks are in a special situation. On the one hand, the artificial intelligence (AI) investment boom continues to support major stock indexes; on the other hand, rising geopolitical risks, continued rise in interest rates, and uncertainty brought about by the US midterm elections also constitute factors that may cause market fluctuations.

Eric Diton, president and managing director of The Wealth Alliance, said that as long as the US economy and corporate profits continue to be strong, the stock market will still be able to withstand high bond yields for the time being. However, he warned that if there is a problem with AI infrastructure construction and corporate profit expectations are lowered, the market may face broader selling pressure.

The following five aspects reveal the pressure that is accumulating under surface calm in major US stock indices.

Weighted indices such as the S&P 500 are likely to fall for seven consecutive weeks, and market gains will be further concentrated

Weighted indices such as the S&P 500, which are important indicators for measuring the breadth of the US stock market, are facing the risk of falling for the seventh week in a row. Unlike the traditional S&P 500 index, which gives higher weight to large companies according to market value, the equal weight index gives each constituent stock the same weight, so it can more intuitively reflect the overall performance of common constituent stocks.

According to the data, if the index fails to reverse its decline as of Friday, it will be the third time in history that it has declined for seven consecutive weeks. The previous two occurred during the market adjustment period after the collapse of the Internet bubble in 2002 and during the US stock bear market in 2022, respectively.

This phenomenon shows that although the S&P 500 index is still close to historic highs, the upward momentum is mainly concentrated on a few large technology companies, and the performance of most other stocks is clearly lagging behind.

However, not all market participants believe that the narrowing of the market breadth means that this bull market is coming to an end. Tallbacken Capital Advisors CEO Michael Purves said in Thursday's report that he doesn't think the current market breadth imbalance is a reason to be bearish on the S&P 500 index, but rather sees it as a sign of a strong bull market driven by technological change.

Purves gave the S&P 500 index a target of 8,500 points at the end of the year, which means there is still potential room for growth close to 11% from the current level.

Small-cap stocks are close to a pullback range, and more than one-third of companies are under pressure to repay their debts

As interest rates and bond yields rise, the impact on small business stocks is particularly pronounced. Compared to large enterprises, small enterprises usually bear a higher debt burden and have a relatively single business structure, so they are more sensitive to rising financing costs and changes in the economic environment.

According to the data, the Russell 2000 index lagged significantly behind the S&P 500 index in the third quarter that just ended, and the difference in return between the two was close to 10 percentage points. This is the second-worst quarter since 1999 for the Russell 2000 index compared to the S&P 500.

Up to now, the Russell 2000 Index has fallen 8.5% from the all-time high set on August 14, close to the technical pullback range usually defined by a cumulative decline of 10%. Judging from the industry structure, financial and industrial companies account for a relatively high share in the Russell 2000 Index, while the S&P 500 index is more dependent on tech giants benefiting from the AI boom this year.

What is more noteworthy is that financial pressure within small-cap stocks is increasing. According to data, more than one-third of the constituent stocks in the Russell 2000 Index are so-called “zombie companies,” that is, companies with weak operating conditions and difficult to cover debt interest expenses with their own profits.

As financing costs continue to rise, the financial burden on such companies may further increase, and small-cap stocks as a whole will face greater valuation and profit pressure.

Bank stocks fall into a technical correction, AI agents heighten market concerns

Even though US consumer spending is still strong and corporate lending activity continues to provide some support for banking business, bank stocks have been clearly sold off recently. The KBW Nasdaq Bank Index, which covers 24 major banks, has fallen by more than 12% from its high in mid-August and has entered a technical correction range.

Since this year, the index has risen by only 3.3%, which clearly lags behind the S&P 500 index's increase of about 12%. The pressure on bank stocks is mainly affected by factors such as rising financing costs, rising bond yields, and heightened market concerns about credit risk. These pressures have weakened investors' confidence in banks' short-term profit prospects.

Furthermore, the Muse AI agent launched by Meta (META.US) has also brought new uncertainty to the financial sector.

The market is concerned that AI agents may change consumers' long-standing bank account usage habits. For example, in the past, consumers may have kept funds in current accounts with low returns for a long time due to complicated operations, and AI agents are expected to help users compare financial products and transfer funds more easily, thereby weakening the traditional advantage of banks relying on low-cost deposits to obtain profits.

Looking at individual stock performance, First Capital Finance (COF.US), Wells Fargo Bank (WFC.US), and Huntington Bank (HBAN.US) were among the weakest performing constituents in the KBW Bank Index this year, falling about 20%, 14%, and 12% respectively during the year. Citigroup (C.US) fell 4.6% intraday on Thursday, the biggest intraday decline since July.

Utility stocks fell from a higher point by about 17%, and the traditional defense sector lost its appeal

Utility stocks, which are generally regarded as defensive investment choices, have also become one of the sectors hardest hit by this round of rising bond yields. Since utility companies generally provide relatively stable dividend income, their shares have long been favored by investors seeking returns and stability.

But as US Treasury yields continued to rise, the returns offered by bonds became more attractive than dividends on utility stocks, weakening the latter's investment appeal. According to the data, the S&P 500 utilities sector has fallen about 17% from the historic high set in February this year, gradually approaching the bear market range usually defined by a 20% decline.

In the third quarter of this year, the cumulative increase in US 10-year Treasury yields was close to 1 percentage point, and the utility sector fell 13% during the same period. Of the 31 constituent stocks in this sector, only two companies, Constellation Energy (CEG.US) and AES Power Generation (AES.US), achieved gains. Looking at the breakdown, power generation companies and power utility companies both fell by more than 10% in the third quarter, and their performance was weaker than other categories within the sector.

In addition to rising bond yields, expectations that US gas inventories may increase are also putting pressure on related stocks. At the same time, rising fuel costs may erode corporate profits, while sharp increases in interest rates raise the cost of financing renewable energy projects.

For utility companies that need to continuously invest large amounts of capital to build and maintain infrastructure, a high interest rate environment may simultaneously affect financing costs, profit expectations, and stock valuations.

High-risk technology stocks were sold off, and the performance of financially weak companies lagged behind

In addition to traditional interest rate sensitive sectors, highly speculative stocks in the market are also under pressure. According to the data, a basket of unprofitable technology company stocks tracked by Goldman Sachs fell by a cumulative total of 11% in the third quarter, setting a record for the second worst performance in the third quarter since relevant data were available in 2014.

This stock portfolio includes companies such as the streaming platform Roku Inc (ROKU.US) and interactive fitness equipment manufacturer Peloton Interactive (PTON.US). For growing companies that have yet to achieve stable profits, investors often rely more on valuing future profit expectations.

When bond yields rise, the current value of future cash flows after discounting usually falls, putting pressure on the valuation of such companies. At the same time, companies with weak financial conditions and high debt burdens are also clearly underperforming.

According to data, corporate stocks with the weakest balance sheets and heavy debt burdens in the basket rose only 1.9% in the three months up to the end of September, the smallest quarterly gain since the beginning of 2022. The beginning of 2022 coincided with the Federal Reserve's most aggressive interest rate hike cycle in decades, and the current market is once again experiencing similar fragmentation, indicating that investors' concerns about financing costs and corporate financial health are rising.

Wall Street differences widen, AI investment prospects become a key variable

Despite significant adjustments in several sectors, Wall Street is still divided on the overall outlook for US stocks.

Diton of The Wealth Alliance is cautious about the stock market and is increasing its holdings of energy stocks to hedge against the risks posed by maintaining high bond yields and crude oil prices. He believes that as long as economic growth and corporate profits remain strong, major stock indexes will still be able to withstand higher interest rates, but if there is a problem with AI infrastructure investment, it may trigger a decline in broader profit expectations.

On the other hand, Jimmy Lee, CEO of Wealth Consulting Group, believes that the rise in bond yields will not necessarily continue to get out of control. He said investors may currently only be selling interest-rate sensitive stocks and moving back to the tech sector after undergoing major adjustments earlier this year.

Lee is taking advantage of falling valuations to increase his holdings in financial stocks and industrial stocks, but he also pointed out that if the AI investment boom unexpectedly reverses, it will constitute the main risk faced by the S&P 500 index.