Since the coronavirus lows set in March 2020, the S&P 500 is up an impressive 89.8%. The first few months of this rally featured outperformance from tech stocks, due to increased tech spending and remote working during the pandemic. Then, as the vaccines were announced, the combination of massive stimulus (already issued and in the pipelines) and the expectation of the economy reopening, led to accelerating economic growth for a few quarters. As a result, value and cyclical stocks roared higher, along with technology stocks.
This dynamic changed in February, as tech stocks started to slip lower, while other parts of the market kept moving higher. In recent weeks, the market’s advance seems to have stalled while rotation to certain parts of the markets continues. To be clear, I believe that the market’s underlying fundamentals such as earnings growth, interest rate policy, and economic data continue to indicate that the bull market is in the initial phases of a multiyear move higher.
However, there are increasing signs that a deeper pullback may be brewing. As a result, investors in stocks and ETFs like the SPDR S&P 500 ETF (SPY), iShares Russell 2000 ETF (IWM), and Invesco QQQ Trust (QQQ) should consider taking some risk off the table for the near term.
Here are 4 reasons to be concerned about the market’s near-term outlook:
- Year 2 of a Bull Market
- Sentiment/Positioning Readings
- Performance of Oversold and Leading Stocks
- Economic Data
Year 2 of a Bull Market
Every bull market is unique in terms of its demographics, catalysts, technological developments, and geopolitics. However, they tend to follow the same arc in terms of emotions moving from fear to greed.
Another phenomenon that seems to repeat is the mixed performance of stocks in year 2 of a bull market. If we look at the previous years in which stocks gained more than 70% in a year - 2009, 2003, 1983, and 1976 - the following year have all featured pullbacks of between 15% and 20%.
These pullbacks essentially wipe out some of the excesses created by the bull market and also help rebalance sentiment from being bullish to neutral. In essence, they help lay the foundation for the next advance in the bull market. These pullbacks also turn out to be fantastic entry points for investors as year 2 of a bull market tends to close out the year at its highs as well.
Sentiment/Positioning Readings
Consistent with the previous point is that we are seeing very bullish readings in terms of positioning and longer-term sentiment measures. Now, this isn’t a timing indicator that tells us when the trend is going to turn. But, it does give us some sense of what to expect in terms of return and risk.
When the consensus is bullish, the upside is limited, while it’s the opposite when sentiment and positioning hit extreme bearish levels. At this point, any good news or even negative news that isn’t as bad as expected can send stocks shooting higher.
Recently, the Merril Lynch Bank of America Global Fund Managers Survey revealed that institutional investors and large funds have their lowest cash position and highest exposure to stocks in more than a decade. Further, 91% of managers expect economic growth to continue increasing in the coming year, while 89% of managers see corporate profits continuing to improve.
We have experienced the ramifications of such bullish sentiment and positioning this earnings season. Many companies beat expectations and issued guidance beyond consensus forecasts, yet their stock prices sold off despite this good news. This is one consequence of such bullish positioning which can lead to a market where participants are selling into good news.
Performance of Oversold and Leading Stocks
Another point of concern is more observational. Over the last couple of months, we’ve seen serious selling in certain pockets of the market, while the broader indices have kept moving higher. Some of the most affected groups are the high-multiple growth stocks such as the coronavirus beneficiaries, the cannabis sector, and crypto stocks.
Despite hitting extreme oversold levels, the bulk of these stocks have failed to put together a meaningful rally. To me, this is a concern that these significantly lower prices are not inducing enough demand for even a retracement. This means that the selling in these industries is not over which is a headwind for markets.
At the same time, many of the leading groups which accounted for the market’s strength over the past couple of months such as commodities, industrials, and housing stocks have started to wobble. This is a normal and natural development given their impressive gains so far this year, however, it is concerning that no new leading group has stepped up to take their place. Until this changes, investors should adopt a more risk-averse stance.
Economic Data
One theme of much of the past year was analysts consistently underestimating the economy’s strength. This is evident in the Citigroup Economic Surprise Index below.
Now, we are seeing a much different picture. Analysts have increased their forecasts, and in recent weeks, we’ve seen some big misses, specifically in terms of housing, jobs, and consumer sentiment.
Again, this is a pretty typical development for a more mature bull market. However, it simply is another piece of evidence indicating that the market environment is going to get more challenging than the past year. It’s now abundantly clear that the economy in terms of second-derivative measures has peaked. Investors and traders should adjust their strategies and risk appetites accordingly.
Conclusion
Despite these near-term headwinds, it’s important to reiterate that the market remains firmly in a bull market that is underpinned by earnings growth and low rates. Further, most parts of the economy are growing, which is a rare development and is consistent with a multiyear bull market.
Even within the confines of this bull market, there will be periodic episodes of selling that are serious enough to reset sentiment and positioning to more neutral or bearish levels. Based on recent developments, it seems that we may have to endure such a period before the bull market resumes its ascent.
Of course, a challenging market environment doesn’t mean there won’t be opportunities on the long side. These types of markets often provide incredible opportunities for big returns in short periods. Further, when market conditions do start improving, there will be tremendous opportunities to pick up high-quality stocks at a discount.
The POWR Growth service is dedicated to identifying these opportunities and being vigilant in ensuring that our selections and strategy are appropriate based on current market conditions. Click here to learn more about it.
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SPY shares were trading at $416.55 per share on Friday morning, up $1.27 (+0.31%). Year-to-date, SPY has gained 11.78%, versus a % rise in the benchmark S&P 500 index during the same period.
About the Author: Jaimini Desai
Jaimini Desai has been a financial writer and reporter for nearly a decade. His goal is to help readers identify risks and opportunities in the markets. He is the Chief Growth Strategist for StockNews.com and the editor of POWR Growth newsletter. Learn more about Jaimini’s background, along with links to his most recent articles.
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