Short Term Pain Setting Up Long Term Stock Market Gains

Wealth managers seek a diversified portfolio for most clients. There will always be sectors that outperform and underperform in any given period, but achieving returns that match or slightly exceed the broader stock market is the goal. Last year, Energy stocks were the darlings while mega tech companies were crushed. This year energy and small cap equities have been dead weight while mega cap technology stocks have regained their leadership. The stampede into the top 6 market value stocks accelerated in March when bank failures triggered a panic out of regional banks and concentrated fund flows into the only game in town – mega capitalized technology stocks and the grand promise of Artificial Intelligence (AI). Apple, Microsoft, Alphabet (Google), Amazon, Nvida and Meta account for over a $9 trillion valuation and dominate the over-hyped AI craze. The surging disparity of this group compared to the weak performances in the broader marketplace have created negative divergences that keep managers from embracing this selective Bull market move in recent weeks. The Dow, Russell small cap and the 2,000+ stocks on the New York Stock Exchange show no gains when these 6 tech stocks are removed. Thus, most investors have almost no profits in their portfolios this year, reflecting an unhealthy broader market inertia that has concentrated risk in a very narrow group of stocks.

A well-used measure of stock market breadth compares advancing and declining (A/D) stock issues with the overall price of the stock market. When A/D moves lower while prices push higher, it’s a warning that the broad stock market is being selectively bid up by a smaller number of companies. These divergences are somewhat uncommon and normally herald a correction ahead. While the promise of AI and dominate technology companies continue to carry all the water for the stock market, the A/D yellow flag indicates this is not the time to add equities to a portfolio until prices correct.

Further short-term technical cracks have begun to appear among stock option traders that have been buying Bullish Call options at a pace that warrants some near-term corrective action over the next month. Further tech inflows surrounding rumors of passing a new Federal Debt Ceiling could allow for another spurt higher into short term overbought levels in early June, but gains may be short lived until prices can pull back. 

Now for the good news after any short-term pain: The well-known 200 day moving average (dma) of stock indices can be a good indication of long-term directional change confirmation. Being a 200 dma, the confirmations will of course lag precise tops and bottoms. Historically, Bear markets don’t continue once the SP moves above its rising 200 dma and prices continue to move up longer term. If accurate again, this hints that any economic slowing over the next few quarters will not be severe enough to trigger a new Bear market in equity valuations.

Commitment of trader reports are also at historically oversold net short positions that favor Bullish stock market conditions – or soon to be Bullish after some corrective action this summer. When Managed Money (large speculators) are heavily net long, such as in Q1 and Q3 2018 and Q1 2022, it was excellent time to raise cash and prepare for a market decline.  At the other extreme, in Q3 2015, Q1 2016, Q2 2020 and Q4 2022, it was an opportune period to Bullishly add equity to portfolios. The record net short hedges held by Managed Money today while the SP 500 Index is rising could indicate further gains immediately ahead or that a strong resumption of the uptrend will be ready after the normal one-to-two-month correction.

The weekly SP chart with our proprietary indicators is more of a mixed bag. The breadth and option sentiment components have both moved back into the overbought zone for the first time since the February peak. This supports the case for market weakness over the next month. The small investor metric (blue line) has drifted back to an oversold negative sentiment level. Investors seem to be infected by the constant barrage of economists and money managers sounding alarm bells for the past 17 months, warning of an inevitable recession. CEO’s, money managers and individual investor surveys are in sync and worried about the fallout from high interest rates, inverted yield curves, restrictive lending by banks and the risk of contracting corporate earnings. Seasonality allows for some corrective action as we move through June, but defensive money managers and investor pessimism provide a positive backdrop for stocks when market pullbacks arrive.

Bears have been proven wrong for the past 8 months since all the major stock indices bottomed out last October. The strong and persistent consensus that the economy, labor and earnings will worsen over the next year provides both pent up future buying power for the stock market while also tapping on the brakes near term due to uncertainty ahead. In the here and now, the data does NOT show signs of recession and a coming surge in unemployment. The first quarter corporate reports are now in with 78% of companies beating expectations. The average company – including the beleaguered small caps – topped profit estimates by over 6.5%. The trailing 12-month earnings appear to have bottomed and are now heading higher, according to Ned Davis Research. “This is a very strong signal that all the worries about the impending recession have been greatly exaggerated”. The higher for longer restrictive interest rates also reflects short-term headwinds that will lead to longer term gains when the negative sentiment over the past year finally reverses. With money market yields now breaching 5% and 4-month risk free Treasury Bills yielding over 5.4%, investors are increasingly taking cash from their stock portfolios. However, with full employment, very strong individual and corporate cash reserves, this will add to the eventual buying power to fuel stocks much higher once inflation and short-term interest rates fall under 4% again.




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