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The reset in long rates (fueled by a rise in the term premium) is the primary driver for the market right now. The timing—just as the P/E-driven phase of the stock market’s rally comes to an end—is causing indigestion. The S&P 500 is correcting the symmetrical advance from the

The market has stumbled, some parts more than others. The downside leadership is dominated by the mega caps, which of course led most of the way up.

Mega-cap stocks have retreated the most, but even the S&P 500 equal-weighted index is seeing a meaningful correction: It’s back into the large range that has defined the price action of the past 12 months or so. The base breakout I expected a few months ago will have to wait.

Like the S&P 500 equal-weighted index, small caps are seeing a meaningful correction, falling into the middle of their range from the past year. Momentum for a breakout seems to have dissipated for now.

Portrait of a market muddle: The forward P/E ratio for the S&P 500 has now corrected 1.2 points from 20.3x to 19.1x. Support is at 18.5x. Breadth is reaching modestly oversold levels, with 34% of the index trading above its 50-day moving average.

Jaws, Wall Street style: Look at the difference between current stock valuations and a standard discounted cash-flow model (which assumes 6% long-term EPS growth and a 4% ERP) on one side, and what is suggested by real rates and the Fed on the other. That spread is a beast.

If the valuation phase of this presumably early-cycle bull market is over—and that’s how it looks—then it will be up to earnings to carry prices higher from here. We’ll see if the “E” is up to the task.

What's next for stocks? Much of that will depend on earnings, which are expected to bottom in Q3. Both Q1 and Q2 showed that earnings growth was less negative than expected—a good sign. Meeting or beating consensus in the quarters ahead will be key for market momentum.

Even if earnings pivot higher, as expected, remember: The S&P 500 already rallied five P/E-points in expectation of exactly that scenario. We must juxtapose this against the ongoing inversion of the yield curve. Sustained rallies in the face of an inverted curve are very rare.

With yields back to their cycle highs, I’m reminded of the old Fed model, which was very popular during the Greenspan era. Is it relevant to today's market? 🧵

There’s a simple adjustment we can make to the Fed model, which is to strip out the term premium. What’s left is called the risk-neutral yield. The chart below shows this. /4

While the valuation spread is still not at the extremes seen in 1987 and 2000, the model shows just how far the valuation of equities and bonds has corrected. /END

Financial conditions are tightening, as you might expect when stock prices are falling and yields are rising. The Fed probably doesn’t mind.

What’s next for the Fed? All eyes are on Jackson Hole and what might be said about R-star, important to gauging the economy’s long-term potential, and whether it is as low as the models say. If not, it may throw some cold water on hopes for a Fed pivot in the near future.

Eye on bonds: For the long end, the term premium has rallied from -91 bps to -37 bps in just a few weeks. If the premium reverts to its historical tendency to be positive, it could mean a 5-handle for long bonds.

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I did not have two major rain events on my bingo card for this year’s burn. There’s nothing we can do but shelter in place until the playa dries up. We did get treated to the most incredible double-rainbow. The playa provides, in one way or another.

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