Seasonals Support A Summertime Rally

Seasonals Support A Summertime Rally

June 07, 2023

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Today’s market concerns involve the S&P’s ongoing struggle to rally through 4,200 resistance. Although this hurdle was accomplished last week, the difference in performance between large-cap growth and the balance of the equity market is truly “the” issue. This has led some to see vulnerability in Technology (which is what is leading the charge) based on the potential for a bearish “catch-down” (or digestion) scenario—this is where we take issue. Will Tech continues to rise in a straight line? We surely don’t think so. However, our methodology is based on the assumption that areas of relative strength should be bought on weakness, and areas of relative weakness should be sold on strength. Many of you have heard me say it like this, “pick your weeds and water your flowers.” Credit is given to my friend Ashok Patel for this eloquent quote. We think lagging areas are prone to continue to underperform on a market slide too. Said differently, a bullish “catch-up” trade is the likely catalyst for the next meaningful market rotation, in our view. We don’t think owning market leaders would be crippling in that scenario and should continue to outperform otherwise.

In today's letter, I am going to go over several different issues which I feel are imperative for you to have a fairly clear understanding of so that you feel comfortable with where the markets are currently. I want to begin by finishing my final comments on the Debt Ceiling issue that I wrote a Special Report on Friday about, next I want to go over the broad markets of the S&P 500 and the NASDAQ 100 and where they are currently, last I will go over what I believe we are seeing and what the second half of the year could look like. 

Debt Ceiling Story and What's Next?

On Saturday, President Biden signed the legislation that was negotiated between him and Speaker McCarthy. The deal was signed in time to avoid the crisis of a US Government default which Secretary Yellen kept blathering about. All this worry about the US defaulting on its debt is a broken record as far as I'm concerned. The US has never defaulted on its debt from a failure to raise the debt ceiling. The circus tends to get resolved at the last minute with both sides claiming victory as the mainstream media whips up worst-case scenarios that have never happened! The politics of getting the bipartisan bill passed showed how Washington can work as the legislation passed both Chambers with large bipartisan majorities. I know there are Representatives from both parties who don't worry about the general election but think about how a vote might impact a future primary (my entire issue with our political process, but I digress). The NO vote from the Republican side came from its extreme right Freedom Caucus, and the NO votes on the Democratic side came from members of the progressive left, as was expected! The meat was as follows:

  • Biden was able to get the threat of default during his administration off the table with a suspension of the debt ceiling until after January 1, 2025.
  • The Defense budget was increased by 3% with a focus on Ukraine, the US border, and strengthening forces in the Pacific Rim to deal with the growing China fear.
  • Supplemental spending bills for unexpected emergencies like natural disasters like hurricanes or unexpected global events like the Russian invasion. 

Is the Stock Market Going to Catch Its Breadth?

The concern facing the market according to most media writers seems to be the concept of market breadth. What this means is that if the broad market index is lifting its price level and moving higher, it would be "logical" that the number of companies with a positive vote in the index would also be moving higher. Not true!!! In Barron's over this past weekend, Professor Aswath Damodaran, known as the “Dean of Valuation” was quoted as saying, "This lack-of-breadth thing drives me crazy. You know what? Markets never have breadth." He recently looked at 80 years of market data and found that big bull runs were commonly carried by 10% of the stocks or less. Boom, mic-drop, please. 

So, let's look at the charts of the major indexes. The NASDAQ 100 houses the current darlings, the large technology charts. As can be seen below, it is clear that the highs were back in November of 2021, the bottom was in October of 2022, and this bounce has eclipsed a good majority of the decline in the face of too many negatives to mention.

The next chart is that of the S&P 500, which tends to be the broad benchmark of the overall US market. It is important to note that the S&P is a Cap-Weighted Index. This means that the bigger companies have a larger vote in the price of the index. So, if one were to remove the "Magnificent 7" (the Large-cap tech companies) from the index, the index would be down for the year 2023. As it stands the index is up around 12%, so it should be no shock that these big-cap tech juggernauts are pulling up the index and reflecting what the Dean of Valuation was quoted as saying above that over the last 80 years, big bullish moves in the market were commonly carried by only 10% of the stocks or less.

The indexes shown above are reflective of a broad market that is advancing almost despite itself. Taking into account a war, runaway inflation, a 15-year high in interest rates, a Debt Ceiling standoff, and massive amounts of sideline cash, the markets are still up quite handsomely from those October 2022 lows, that is, if one is to own the correct index, sector and/or individual companies. 

What's Next for the Markets?

We know what gave the markets a bad case of indigestion, and along with it, reasons for investor flight. But even though the news continues to be negative, what has changed? Has anything changed? According to the Market, the answer is Yes! 

  • The US is not poised to default anytime soon.
  • The Ukraine-Russia War, at present, has not escalated into a global conflict.
  • This weekend we had an agreement on oil production and a clear understanding that Russia is pumping oil into the system furiously. 
  • Fed speakers seemed to indicate at the end of last week a pause in interest rate hikes. 
  • Longer-term interest rates have topped out and seem heavy at these levels and are declining. This has created an unprecedentedly high level of dry powder of cash on the sidelines. 
  • From a sentiment standpoint, it is a vote of extreme pessimism toward risk assets by investors. This represents an explosive level of buying power. 
  • The lingering fear of recession persists, yet labor numbers released last Friday speak otherwise.

Therefore, barring an escalation in any of the above-mentioned issues, the equity market should continue its expansion. Even though last week many wanted to sell the news of the US Treasury getting what it needed in the Debt Ceiling agreement, I believe that the risk to the markets is being overshadowed by the outsized cash sitting in money market funds and the massive institutional short positions. As soon as the massive bearish opinion dissipates, things could certainly change and change quickly. In Monday's Wall Street Journal, there was an article titled, "Bearish Bets Escalate, Except in Tech." It began with the statement that Wall Street hasn't been this bearish on the stock market in more than a decade, except in the case of big-cap technology. Hedge funds and other large speculators have built up huge bets that the markets will decline. They keep hanging their hat on the fact that the S&P would be negative for the year if it weren't for the seven big techs I mentioned above. They go on to bring up the factoid that the length of time of this decline has been the longest bear market since 1948

If one were to ignore all commentary and just pay attention to the price, the moving average price levels that have been in decline since the end of 2021 have now reversed and are rising. This often provides a rising channel for the broad index to move higher and it is doing so.

At the same time, the fear of earnings collapsing is now more of a recovery after throwing the kitchen sink of bad news into the earnings mix over the last year and a half. This also brings up the concept of earnings and valuations. Many prognosticators are commenting on how current price levels are not justified based on earnings. The point that is often forgotten is that the markets are a discounting mechanism. They reflect what is expected 12-16 months out, not recent history. See the chart below of earnings by sector, courtesy of FundStrat. You will notice that they are giving focused attention to the industrials. 

The last two points I want to end with are the intensity with which net speculators are positioning themselves for a decline. This seldom ends up working out for the speculators. And as the dust seems to be settling on major negative issues, it is clear that this time should be no different.

The last point that I want to cover is the concept of breadth in general. Most people are concerned that there are too few companies pulling the markets higher. I believe that this should be looked at another way. Instead of focusing on how fragile it appears that only a handful of companies are pulling markets higher, instead, I believe one should focus on the laggards. When I say laggards, I am referring to the small-cap index and the mid-cap index. If these parts of the markets begin to get stronger instead of declining, this means that the "worst" parts of the market are now becoming "less bad." If these large market segments begin to recover and slowly advance, this is the beginning of the breadth expansion and things could get really serious!

We question if the market is worried about lofty valuations when the cheapest stocks are weighing most on the averages. Similarly, we think investors worried about market breadth should be worried about the areas limiting participation, including value stocks. Here too, should the market be correct, we’ve found that weak often get weaker meaning the losses in Russell 1000 Value are the losses less likely to be recouped on a subsequent rally. We think the rotation into a value is more likely to be driven by bullish “catch-up” than bearish “catch-down.” Growth stocks should continue to outperform otherwise, by our analysis. Stay tuned!

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Important Disclosures: 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy. 

Investing involves risks including possible loss of principal.

The Standard & Poor's 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors.

The Nasdaq-100 is a large-cap growth index. It includes 100 of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market based on market capitalization.

The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

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