Oversold Stocks Down but Not Out

The stock market is a decent looking glass into our economic future and may have anticipated the huge third quarter GDP surge of 4.9%. The three months of weakness since then may also reflect a relative slowing into year end and early 2024. The benchmark S&P 500 Index fell a significant 11% over 3 months into late October, breaking key support and moving below its widely followed 200 day moving average. On the plus side of the ledger, price to earnings (PE) valuations fell from a frothy 20 in July to a fair value of about 17 in October while corporate earnings moved back up to record highs. ExecSpec warned investors in late July to expect stocks to top out and head lower into October. Other than the profound weakness among interest sensitive small cap stocks, the equity markets have behaved as expected without signs of a renewed Bear market. This does not mean the skies are clear for a smooth flight, but evidence continues to support a healthy trading range affair near the parameters of the past few months.

Commodity Trading Advisors (CTA’s) and Hedge Funds in the US and Globally have moved to extremely negative equity positioning in their allocations. As contrarians we assume this portends a market low at or near the October 27th lows.

The NAAIM survey of money managers reflects a similar indication of excessive pessimism. Thus, excess cash has built up to propel valuations higher during this seasonally strong time of the year. However, with the technical damage to the broader market and rapid decline in checking accounts by the bottom 80% of income earners, we would not expect a roaring rally back above the summer peak until interest rates fall more precipitously.

One lingering concern for investors is the never-ending breakdown in small cap stocks. It’s implausible that a healthy stock market up cycle can have strong legs without broader participation from banks and small cap stocks. Our assumption has been tethered to bond yields. While yields have likely peaked, inflation needs to move closer to 3% for interest rates to fall rapidly and trigger a disproportionate rally amongst these small cap laggards.

In the first half of 2024 we suspect the less expensive equity sectors will become outperformers once again.

Our past reports were confident that August and September would be weak for the stock market with a volatile October low evolving into a positive trend through most of November. The seasonal chart below highlights the consistent buying power that should boost equities after the unusual 3 straight months of decline. 

Beyond this potential November strength, we see a record number of company reports this quarter that are concerned about falling demand that should keep prices well below their summer peak of 4600+ on the SP 500 Index.  This will increasingly quell rate hike fears and provide more of a trading range atmosphere for stocks once the year-end rally runs out of steam over the Holiday season.

Short term rally in stocks was confirmed on October 31st as oversold stochastics had a Bullish crossover that coincided with a short covering rally that we expect to carry into mid-November.



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