Why the stock market will struggle to rally until debt ceiling, bank woes are in rearview mirror

No surprise, the culprits are the persistent worries about regional U.S. banks following the collapse of Silicon Valley Bank and Signature Bank in March and the subsequent demise of First Republic Bank, along with the latest debt-ceiling showdown in Washington that threatens to tip the federal government into a first-ever default in early June.

‘Capping’ rallies

For now, those concerns can be described as “capping” rallies rather than “resulting in a downdraft,” Anastasia Amoroso, chief investment strategist at iCapital, told MarketWatch in a phone interview.

But if more banks look in danger of failing or if the path to a debt-ceiling deal gets more rocky, investors should be prepared for a significant, but “buyable,” pullback, she said.

Need to Know: Why the stock market has actually thrived as regional banks flounder

Meanwhile, investors appear content to pile into tech stocks, particularly the biggest of the so-called megacap names, in something of a flight to safety that has sparked separate concerns over the durability of the stock market’s 2023 rally.

The S&P 500
SPX,
-0.16%
fell 0.3% last week, while the Dow Jones Industrial Average
DJIA,
-0.03%
dropped 1.1%. The S&P 500’s decline was cushioned by megacap tech-related stocks, which also helped lift the Nasdaq Composite
COMP,
-0.35%
out of a bear market, gaining 0.4% last week.

Stock-index futures were modestly lower Sunday evening.

Bank worries

What are investors worried about when it comes to the banks? The SPDR S&P Regional Banking ETF
KRE,
+0.64%
fell more than 5% in the past week as the sector was led lower by a renewed fall in shares of Pacwest Bancorp
PACW,
-2.99%,
helping sour the tone for the broader market.

See: The regional-bank crisis did not appear over on Thursday

While the 2007-2009 financial crisis was driven by fears of insolvent banks, the problem for regional banks is centered on liquidity, said Tom Essaye, founder of Sevens Report Research, in a Friday note. That means fears of “contagion” aren’t in play. Instead, the worry is economic.

“If banks are worried about deposit runs, they will keep more capital in reserve than they normally would. That reduces the available pool of capital to make loans,” Essaye wrote.

“Additionally, if banks think their regulatory costs will increase (and they absolutely will) or regulators are going to deeply investigate their operations, they’ll hold even more capital in reserve, further reducing the capital available for loans. The result could be a widespread reduction in lending in the economy,” he said.

In other words, a credit crunch.

Debt-ceiling showdown

Meanwhile, the stock market appears for now to be looking past the debt-ceiling drama in Washington. The second round of debt-ceiling talks between the White House and congressional leaders appears set for Tuesday, President Joe Biden said Sunday.

That said, volatility in the usually sleepy market for Treasury bills and a sharp rise in the cost of insuring U.S. government debt against default using derivative instruments known as credit-default swaps shows investors aren’t without unease.

See: Treasury bills, epicenter of market’s debt-ceiling worries, reflect doubts about a resolution

The stakes are high. A brief default would deliver a hit to U.S. real gross domestic product, could cost almost 2 million jobs, and send the unemployment rate toward 5%, iCapital estimates. The stock market isn’t positioned for that kind of economic hit nor for the potential rise in volatility, Amoroso said.

Don’t miss: How $4 trillion in Treasurys parked at banks could become a ticking time bomb if the debt-ceiling fight triggers a U.S. default

Given a history of brinkmanship around debt-ceiling talks, there’s a strong chance talks go down to the 11th hour. If so, it isn’t hard to imagine a late breakdown that sparks an equity pullback of around 5% or so, she said, while a prolonged impasse could see a drop of as much as 10%.

Related: Here’s where investors may turn to ‘hide’ as U.S. debt-ceiling deadline looms based on 2011 market reaction

“I think the biggest thing investors shouldn’t do right now is try to chase the market,” Amoroso said, arguing that a pullback would likely prove to be “buyable.”

Tech concentration

Meanwhile, what should investors make of resurgent tech-related stocks?

The top 10 stocks hold a 29% weight in the S&P 500, and are responsible for around 70% of year-to-date performance, said Ross Mayfield, investment strategy analyst at Baird, in a Thursday note. Within that top 10, seven of the leaders are “Big Tech” stocks, including the five largest, with Apple Inc. 
AAPL,
-0.54%
and Microsoft Corp. 
MSFT,
-0.37%
alone accounting for roughly 14% of the entire S&P 500.

In One Chart: The S&P 500 is top-heavy with tech. Here’s what that says about future stock-market returns.

Narrow concentration, or a lack of “breadth,” can make investors nervous.

A handful of names leading the market “is never considered healthy when there’s vast underlying weakness,” said Quincy Krosby, chief global strategist for LPL Financial, in a note.

But Krosby and others said the current setup is less a cause for alarm. With markets and the Federal Reserve attempting to make sense of a number of inconsistent signals, it makes sense for big tech to serve as a defensive stronghold, she wrote.

Amoroso at iCapital agreed. “There’s a lack of compelling opportunities, which presents one big compelling opportunity [in tech] because of secular growth, fortress balance sheets and little interest-rate exposure,” she said.

Krosby said that as worries overhanging the market begin to unwind, it would be helpful, and expected, to see other sectors, along with small- and midcap stocks, play catch-up.

Economic data and earnings releases in the week ahead could help broaden market leadership, she said, while positive developments around the debt ceiing would help underpin market sentiment.

“Until then, the market will have to contend with a case of bad breadth,” Krosby said.