The stock market has ignored any and all resistance over the past three months. It has been a steady grind higher with practically no downside along the way in the major U.S. indices. I will begin with a chart of the S&P 500 showing its action this last week. The index is at a new all-time high and has almost “casually” trended sideways at this breakout almost appearing to be catching its breath. Even the recent slowing of momentum of the advance and softening breadth underneath the surface (number of new companies adding to the charge of the new high list) have done little to actually produce losses in the averages. However, the market has now reached a point where we really need to sit up and pay close attention.
After being net sellers in April following Tariff / Liberation Day, foreign investors flooded back into U.S. markets in May. Bond purchases also climbed to a record totaling $204.3 billion. Equities purchases were the fourth largest on record with $114.3 billion. After repatriating funds in April, U.S. investors ventured back overseas with net purchases of $59.1 billion of foreign securities, more than what they sold the month before. Almost 86% of those were in equities. Netting U.S. outflows against foreign inflows produced a net inflow of $259.4 billion. Three-quarters, or $195.9 billion, were in bonds and the remaining $63.5 billion was in stocks.
The main risk that I see is the bond market and interest rates. Should the interest rates continue to spike. If they were to spike, this would begin to provide an attractive alternative to stocks and maybe attract capital from a stock market that is at new highs. I don’t believe that the 10-years US Treasury will go above 4.7%, but if it should this would be a shorter term new high in this rate and could suck some of the money out of the stock market. Here is a chart of the 10-year with the new downtrend line being broken and the rates starting to show a new move higher. I have put in a yellow, horizontal line up at the 4.7% point to show where my cautionary concerns could begin to manifest:
The other concern that I have is based on the cycle work from Mark Newton of FundStrat. He illustrated last week that a cycle high could be in making in the S&P 500 at the end of July. As can be seen in the chart below, this cycle work accurately correlated to the low in late 2024, the interim high in April of 2024, a low in late August , the high at the end of the year, and most noticeably it telegraphed the April pull back and the highs that we are currently experiencing. Please note that as the cycle changes it doesn’t necessarily telegraph major moves, but rather that the counter trend by prices could be challenged and given that the markets have been straight up since April, this would not be completely unexpected:
I want to be clear that we have not gotten any indications of investor’s sentiment getting overly bullish (we clearly are not there), breadth breaking down (if anything we have only been seeing the opposite), and we would need to be seeing trend failure where price levels of indexes, leading sectors, and leading companies within this sectors begin to break down. This would be needed to confirm some kind of selling.
The next big picture chart that I believe is of importance is the “Seasonality Chart.” This is the one that takes into account all the years since 1949, with a focus on different Presidential years. Note that the black line of “all post-election years” is the one that appears to be most consistent with what we are currently experiencing. It has a good run up for July, a digestion for August and September, then a continuation of an uptrend into yearend:
The biggest key that I see to a continuation of the current move higher is the technology sector. It has seemed to be the leader both in size of its vote in the indexes as well as the amount of its progression higher. According to consensus earnings, EPS growth should be led by this group again for the next few years. The targets for EPS growth are derived by institutional opinion, and below is the expectations as illustrated by the FundStrat crew. It is important as it gives clear numbers of all the major sectors and what is to be expected going forward. I provide this with a high level of trepidation as things could change rapidly due to political positioning and global conflicts, but I feel it is important to know where the institutional marketplace feels economic growth could come from:
Technology still the elephant in the room, namely semiconductors and software.
The chart above is quite broad in its sector explanation, so I thought I would get a bit more granular so that it is a bit easier to visualize what is driving the numbers. The Tech sector is made up of five industries, but just three – Semiconductors, Software, and Hardware – make up more than 90% of the sector’s market cap. It is no surprise that when profits are to be taken the weighting of these in institutional portfolios would be cut back. Since then, all have outperformed, with the exception of Hardware. Importantly, Semiconductors and Software have been particularly strong, up 65% and 42% from the low, respectively. Again, this is hardly a surprise given that all the goblins plaguing the market have virtually no effect on these sectors and these sectors continue to be the growth engine behind all other sectors and are highly deflationary at the same time. See chart below:
Reviewing the second quarter
The second quarter was one for the history books. In the two days after President Trump’s Liberation Day tariff announcement, the S&P 500 tumbled 10% for only the fourth time since WWII. The other three were October 1987, November 2008, and March 2020 – dates known to even casual market observers. As remarkable as the decline was, the rebound was even more historic:
- The S&P 500’s 12.1% correction from April 2 -8 was the biggest intra-quarter decline to be erased within the quarter since at least 1928.
- Starting at the February highs, the rebound was the quickest back to an all-time high from a correction of at least 15% in the S&P 500 (table, below). The fact that the 18.9% drop was the smallest aided the recovery, but similar corrections in 1990 and 2018 took months longer to recover.
- For the second quarter, the S&P 500 gained 10.6%, the most since Q4 2023 and 11th-best in the past quarter century.
So, this brings us to today. We have begun to get earnings for the second quarter, and I feel these are particularly important as they take into account the new tariff issues, the new inflation expectations and more importantly how earnings are coming in verses what was expected.
Q2 earnings season kicked off last week. Thus far (through Friday), just 58 (12%) of the companies in the S&P 500 have reported, but the result have been surprisingly positive. Prior to the start of the season, Forbes put expected earnings growth at 4.8% from a year earlier. The 12% of firms that have reported are seeing profit growth of 10.5%, more than double expectations. If earnings should continue on this trend, it is quite understandable why index prices continue at highs.
In closing, the next question that I ask myself is where is the beef? Where could we expect future market progress to come from? To answer that, I first want to show that strong momentum begets stronger momentum and that at times of market decline, stronger momentum tends to decline less and therefore is still the best place to be. Here is a clear representation of this going back to 1950, separating strong momentum before a cycle top, and after a cycle top:
To show this progression since the market began its advance post COVID, see below:
And last, the depiction of which index represents this high momentum group vs. the S&P 500 in general. I do this analysis to separate the high momentum parts of the S&P from the broad S&P, again, to show how this group truly has been the best place to be. If this relationship should continue to hold true as the median returns have shown above, it could be that the NASDAQ 100 could be ready to embark on another advance. Time will tell, but this seems to be where earnings are progressing the most and benefiting most from low debt levels and greater margin expansion as a result of AI.
- Ken South, Tower 68 Financial Advisors, Newport Beach
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