Why the market can’t afford to ignore the COVID Delta variant

UBS Head of Equity Derivatives Research, Stuart Kaiser, joins Yahoo Finance to discuss how the inflation data is putting pressure on small-cap stocks and the continued effects from COVID-19 as the Delta variant continues to pick up steam around the world.

Video Transcript

- Let's bring in Stuart Kaiser is the Head of Equity Derivatives Research over at UBS. Stuart, great to talk with you once again. So let's just kind of start with-- with how you're thinking about, you know. The setup we're seeing in markets right now.

10 year. 121. We've got the VIX back above 20, equities under some pressure here. What-- what stands out to you on today's tape?

STUART KAISER: You know, good morning. You know, it's pretty interesting. I think last week the discussion points were really around how equity volatility looked too low relative to other asset classes. And frankly, that is kind of typically a warning sign for markets.

And it looks like it's-- it's playing out a bit here today. You know, I think your point on NASDAQ is an important one. You know, last week you had S&P and NASDAQ down. But you had you know small cap stocks down a lot.

And it certainly seems like the realized inflation data we're seeing is-- is starting to be seen as kind of a little bit of a pricing power risk into small cap stocks. And that is kind of put them under pressure a little bit, which isn't completely unexpected, but it certainly happened all at once.

And then of course, you know, the headlines on-- on the Delta variant over in Europe those I think have probably exacerbated stuff. It's hard to know what actually caused the start of this, kind of sell.

But-- but certainly I think the-- the headlines are now coming back into play even though the hospitalization numbers haven't been particularly high yet.

- Stuart, you mentioned the small cab Russell 2000. I mean, it is getting battered here-- here in the pre-market here. It's down about 7% over the past month. How big a red flag is that move to-- to the broader market?

STUART KAISER: I-- I-- I think it's very important just because that was what people were trying to buy is kind of the quote unquote reopening trade, right? It was these smaller stocks. A lot of them in the service industry that had a lot of exposure to improving economic activity.

So I mean, I think it's important. Any time you get these kind of dislocations, you know, they're unsustainable, right? So either-- either small companies to balance or the other markets are going to kind of get dragged-- dragged down a little bit with it.

I think from my perspective, what's maybe most concerning about it that is, you know, smaller cap stocks obviously impacted by the reopening. Generally, small caps a little more domestically facing.

So to see kind of that domestic facing sort of growth sensitive stock under pressure, you know, definitely catches your attention at a time when US economic growth is so strong. So you know, we definitely have our eye on it. It's definitely something that's concerning us.

If I had to again, put a thumbtack in it, it would be just that the realized inflation data has been so strong and potentially that's the part of the market most impacted if we were to get significant price pressures. So you know, it's on the radar. It's definitely important.

Luckily, it's a smaller part of the overall market cap of the indexes. You know, you know, and it seems like right now what people are doing, especially around earnings season is gravitating back into those kind of big cash generating growth stocks at least for a period of time. So it could be that in a couple of weeks. People will pick up the small cap a ton again after earnings of past.

- Hey, sir we just heard the opening bell. Of course, builders first source is having its listing today it's a building materials company. So that's who was ringing there.

Stuart, I noticed you are watching retail flows as we have been frequently. And you pointed out in your notes to us that the retail options, buying pressure gauge has been falling. What does that tell you?

I mean, is that something that presages potentially some volatility on the one hand? On the other hand, what does it mean if those guys weren't in the market and we see this kind of selling pressure?

STUART KAISER: You know, hey, Julie. Good morning. It's good to see you again. I would say yeah, it's definitely something that's on our mind just because retail had grown to such a large percentage of option for us earlier this year. And it was kind of surprising to see, you know, retail buyers kind of back off a little bit ahead of earnings-- since earnings is such a single stock event world.

You might have expected retail to be getting more engaged as-- as opposed to less engaged ahead of that. So you know, whether it was a pretty major sell off. It's a little hard to know obviously.

But I think it's-- it's one of those contributing factors in the sense that the markets are moving lower at a time when demand for that optionality has disappeared. And as we know, retail tends to play for upside, right? Those aren't the type of investors that are hedging and playing for downside. They tend to be buying call options, particularly in-- in large cap tech and popular story type of stocks.

So I think it is notable that-- that-- that flow has come off so much at a time when you might have expected it to be going in the opposite direction. So you know, we'll definitely keep a close eye on that.

And we haven't seen really the same thing on the institutional side. Institutional flows have remained fairly solid even in tech and financials and those sectors. But definitely the retail side has backed off a little bit.

We might argue is a bit of an inopportune time. We've also seen some pressure on crypto and other parts of the market that are largely kind of credited with a lot of retail interest. So you know, maybe the weather's nice and people have a better way to spend their time.

But-- but I do-- I don't know if it's the number one driver. But I certainly think it's a contributing factor to what we've seen over the last couple of weeks.

- Stuart, based on what you've seen with the COVID Delta variant, are you surprised that, that the market still trading at near record valuations what 22 times forward earnings is it time for the S&P 500 to get a 10% haircut? Because it needs to. If growth is going to slow, I mean, why is the S&P still trading near record highs?

STUART KAISER: Yeah. Look, you know, the Delta variant, I mean, I'm not going to claim to be an infectious disease doctor. Of course, I think what we're trying to follow in the Delta variant is what does it do in the hospitalization rates. And I think for the most part, at least in the US, with the high vaccination rates, a lot of people thought or hoped that this wouldn't have kind of the same impact on the economy and the markets that we had last year.

And frankly, that does certainly seem to be playing out a bit. In Europe, you know, they've reacted to in a different way. So it's clearly something at this point that as market participants, we can't ignore and certainly have to pay attention to.

In terms of valuation, look, I think a lot of that has to do with just huge demand for-- for US equity markets. If you look at dividend yields of S&P 500 stocks, a large majority of them are still higher than the 10 year bond.

So you could argue that even though something like a PE ratio might look high. Historically, there are other aspects of valuation such as yield, which make equities, look, you know, still relatively attractive.

So I think, you know, it's eye of the beholder. And investors, I think, are telling you here with-- with a very dovish Fed and with the economy at sort of peak acceleration right now, especially around earnings season. You know, people are still comfortable to own-- own that US equity market.

And if you have to own an equity market, it feels like they're choosing the US over other regions. What's been very interesting year to date, I think is the fluctuation within the markets. You know, a period of tech outperformance, that small cap and back to tech.

And right now, we're sort of on that-- that I want to buy large cap growth cash generating tech stocks. And frankly, those live in the US. So you're going to continue to see demand for it.

So your valuation definitely a talking point. But I do think there are other aspects of equities such as earnings growth and dividend yield that are making people. At least be able to talk themselves into staying in them.

- And Stuart, finally, before we let you go, you mentioned right at the top that volle-- implied value for equities was just a lot lower than a lot of other asset classes. And maybe a tell that we were going to get a kind of period like we're seeing this morning at least.

Specifically the 10 year, just what's happening in treasuries. How important is that for the equity market right now? Because in some respects, we saw the equity market sleepwalk through a 40 basis point decline in the 10 year.

I guess until like last Wednesday maybe we sort of noticed. But how do you think about the role the 10 year plays in equities going forward?

STUART KAISER: Look, I think it's incredibly important. I mean, probably for the last 20 years or so, the market has read higher interest rates as a sign of accelerating growth and generally OK with them. Unless and until inflation starts to track them higher.

You know, I think you are right. The initial part of the pullback or the drop in yields. The market was willing to accept.

And I think one of the reasons was people were, you know, we're just arguing that, you know, growth is strong. Maybe this is some position unwinding and things like that. And the fact is the move that we have now is just too long to be-- too large to be ignored I think. And that's probably what started to disrupt equity markets.

Well, yeah. I mean, our view is generally speaking as long as the Fed isn't tightening, then yields moving higher is probably OK for equity markets because that just means that growth expectations are solid and perhaps improving. And so-- so the move we've seen lower here, I think is troubling.

I think what people are struggling with is, you know, is this really a sign of slowing growth, or is it positioning, or is it foreign yields are so low that their anchor at US yields? So it's a pretty tricky riddle here.

But I think, you know, the main takeaway is the markets are willing to tolerate a modest move lowering rates. But it's now gotten to the point that they're being sort of forced to pay attention just by the speed in the magnitude of the move.

- All right. We'll leave it there, Stuart Kaiser. Head of Equity Derivatives Research at UBS. Stuart, always appreciate the time I know we'll talk soon. Have a great the rest of the week.