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Stocks are climbing a wall of worry lately. Despite horrendous inflation data last week, the S&P 500 and NASDAQ 100 have rallied 4.9% and 5.6%, respectively, since their intraday lows on July 14. The performance for the Russell 2000 has been even better. It's gained 6.3%.

Perhaps, this rally signifies a change in attitude. As Top Stocks' Helene Meisler pointed out yesterday, fewer lows relative to highs are being made daily on the NASDAQ than two months ago. Similarly, up volume as a percentage of total volume has improved. Clearly, some investors have been willing to tiptoe back to stocks. 

Nevertheless, this rally still has "caution tape" all over it.

A boat tilted to one side

Maybe the rally is because everybody's standing on the same side of the boat. The latest Bank of America monthly survey of portfolio managers reports many managers have become risk averse. Specifically, 58% of respondents say they're taking lower levels of risk than normal -- a record that eclipses responses during the Great Recession in 2008. Instead of buying stocks, managers have turned to cash, the U.S. Dollar, and commodities. And those who continue to buy stocks have spent the past four weeks buying defensive stocks, including consumer staples and healthcare, not banks or technology -- sectors that tend to do well when the economy is humming along, rather than sputtering.

There's plenty of reason for pessimism, but the market has a way of punishing the herd. When everybody embraces a trade as a certainty, the market tends to go the other way. Right now, the masses are positioning themselves for a recession. That's not stupid since GDP is falling and consumer sentiment is terrible. However, the "market" hates consensus, and in the short term, a rally hurts the most participants.

Having said that, investors should keep these gains in perspective, because we've been here before. The S&P 500 has had an actionable rally every month this year that has coincided with "peak" negative sentiment readings (a high put-to-call ratio, high bearishness on investor surveys, a spike in the volatility index, etc). 

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Maybe this time it's different. But then again, maybe it isn't. Without hindsight, it's simply unknowable if this move is another head fake bounce or the beginning of something more durable. Sure, I could argue better internals this time around (for example, fewer new lows), but for now, there's simply no clarity. 

Resistance and earnings risk

The S&P 500 is flirting with resistance at its down-trending 50-day moving average. If it can recover that line, perhaps, it's bullish. However, the index recovered the more important 200-DMA in January, February, and again in March, yet it still rolled down to new lows. Similarly, it recovered its 50-DMA in April only to stall days later at the 200-DMA. Therefore, yes, a close above its 50-DMA may be a good thing, but it doesn't guarantee we're out of the woods, especially with earnings season heating up. 

This week, 250 companies are updating investors on their financial performance during the second quarter and 800 companies will report their earnings next week.

In a low-volume, summer doldrums market, the potential for keyword reading algo's to shift buys to sells on bad news shouldn't be ignored. For example, Monday's mid-day sell-off is being blamed on Apple's announcing it will slow hiring. 

I suspect many companies will say similar things this quarter during their conference calls. It's become harder for companies to pass along the entirety of higher input costs to cash-strapped buyers, so operating margin pressures have increased. At the same time, slowing GDP is downshifting product and services demand, the U.S. Dollar strength is dinging earnings for companies with overseas sales, and higher interest rates are causing interest expense on variable rate loans to climb.

For example, IBM was down 6% at noontime today because headwinds forced it to rein in expectations for cash flow this year. In Q2, currency exchange reduced IBM's revenue by $900 million, and management is now guiding that currency could negatively impact it by $3.5 billion this year. 

I doubt IBM will be the only company to issue this type of outlook. So, what's an investor to do? Be patient.

In "Don't Get Run Over by the Bounce, But Recognize It for What It Is," Real Money's James DePorre writes:

"Traders are buying ETFs and various indexes rather than individual stocks, and that is what is driving things. The downside of this sort of index-driven action is that it can reverse very fast since it really has nothing to do with the merits of the individual underlying stocks. It is just big money flow that is looking to catch shorter-term moves. This is not buying by investors that believe the market has hit a low. It is trading of ETFs for some quick gains, and it will end very abruptly."

Although some individual stocks act better than others, DePorre's point is most of the recent buying is to gain quick exposure that can be reversed just as quickly. This paper hands style of buying suggests ultra-short-term speculation, not major funds admitting they're wrong for being bearish and buying.

Until that happens, swing and position traders ought to limit their trading size and embrace a watch and wait mentality with most of their capital. After all, as DePorre writes in "Will Support Levels Hold as We Move Into Earnings Season?": 

"It is trading range action right now, and there is going to be choppy action as investors position for both earnings and the coming Fed interest rate hike. As long as recent lows can hold, there will be some hope-filled bulls, but generating sustained momentum is going to be a tough task with all the unresolved macro issues that are swirling."

The Smart Play

We remain firmly entrenched in a bear market and there's little reason to think that a hawkish Fed is ready to become friendly again, supporting stocks. As famous investor Martin Zweig pointed out in "Winning on Wall Street," picking a fight with the Fed isn't wise. When the Fed's embraced an "extremely bearish" stance (3 or more consecutive hikes within six months) stock market returns in the following year were poor. 

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Bear markets are notorious for fakeouts and shakeouts. It's normal to see fast and furious rallies fueled by short covering fade and rollover. Therefore, short-term, active investors should stay defensive or sit on the sidelines until risk reward improves. Use stop losses to limit drawdown if we roll over and embrace Stock Market Wizard Mark Minervini's concept of progressive exposure (start small and then, if you're successful, increase capital at risk and, if unsuccessful, go back to cash.)

If your horizon is longer, continue playing the long game. There's little reason to accelerate forward plans to average into the markets over the next 12-18 months. The market will always offer ups and downs along the way, and consistent, regular purchases of the index over time remain the best way to position yourself for maximum gains once the bear market is over.

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