The Stock Market Is Entering Its Weakest Months. What to Watch Out For.

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Russia restarted natural-gas flows to Western Europe through Nord Stream 1, but President Vladimir Putin can shut it down again.

Olga Maltseva/AFP/Getty Images

Bad news on the economy was good news for the markets this past week—until it wasn’t.

Equities extended their rebound from their mid-June lows at midweek, with the Dow Jones Industrial Average gaining a bit over 3% from Tuesday through Thursday, the Nasdaq Composite up more than 6%, and the S&P 500 index roughly splitting the difference, with a 4%-plus rise. But those gains were pared on Friday amid weak economic news, leaving the major averages up 2% to 3.3% for the week.

Underpinning stocks was a continued decline in bond yields, with the 10-year U.S. Treasuries falling below 2.80%, well under its mid-June peak near 3.50%. Of more economic import, the benchmark 10-year yield has remained 20 basis points below that of the two-year yield, a much-watched portent of recession.

Even more dramatic was the sharp drop in European government bond yields—just after the European Central Bank hiked its key policy rate by a larger-than-expected 50 basis points, all the way to 0%. In particular, German two-year yields were slashed on Friday by 26 basis points, to 0.36%, after news that the euro-zone purchasing managers’ index had entered recession territory.

While Russia’s brutal war against Ukraine has receded somewhat from the headlines, its impact on the European economy remains profound. Russia restarted natural-gas flows to Western Europe through the Nord Stream 1 pipeline this past week, but President Vladimir Putin can shut it down again—a looming threat reflected in the downbeat PMIs.

In the U.S., the lower government bond yields and better tone in equities also extended to corporate credit. Junk bonds’ yield spread over Treasuries (the compensation for their credit risk) narrowed by upward of 100 basis points from their recent peaks, with the popular iShares iBoxx $ High Yield Corporate Bond exchange-traded fund (ticker: HYG) ending the week up more than 5% from its mid-June lows.

The equity and fixed-income markets alike head into this coming crucial week on a high note, with risk barometers, such as the Cboe Volatility Index, or VIX, relatively subdued. The Federal Open Market Committee’s meeting will be the key focus. Odds heavily favor a 75-basis-point hike in the federal-funds target rate (currently 1.50%-1.75%), as noted earlier. (A basis point is 1/100th of a percentage point.)

As with corporate earnings calls, Powell’s post-meeting news conference will probably be more illuminating about the outlook than the actual FOMC announcement. Earnings reports from megacap technology companies, such as Microsoft (MSFT), Apple (AAPL), Amazon.com (AMZN), and Alphabet (GOOGL), also will set the tone.

The stock market is entering what historically have been its weakest months, especially in years of U.S. midterm elections. Furthermore, notes Rich Ross, Evercore ISI’s keen technical analyst, equities head into August in an overbought condition. For the S&P 500, Ross puts downside targets at about 3500, a 50% retracement of the rally from the March 2020 lows, and about 3200, a 61.8% reversal for Fibonacci fans, with an upside risk to 4200 for bearish traders.

With the Federal Reserve still tightening and seasonal trends turning negative, good news from positive earnings presents investors with the opportunity to reduce risk. And bad news may cease to be good news for the markets.

Write to Randall W. Forsyth at randall.forsyth@barrons.com