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  • The S&P 500's mid-June rally stalled last week.
  • The market doesn't have to retest summer lows. It could simply chop sideways.
  • If the S&P 500 fails to hold 4,100, it could fall below 4,000.
  • Stocks have reached one level of support, but it may be better to buy recessionary and early-cycle individual stocks than the market itself.

After an inspiring rally beginning in the middle of June, the major market indexes ran into stiff resistance at their declining 200-day moving averages. The run-up to levels where sellers typically emerge prompted me to write last Wednesday, “Given that we’ve had a big run in a short period and are now into the thick of resistance, now could be another excellent time to sell some stocks.”

Since then, it’s been a steady slide lower, with the S&P 500 and Nasdaq 100 declining by 3.4% and 4.4%, respectively, through yesterday’s close. The selloff has been more dramatic for early-cycle stocks, including technology, and downright dismal for speculative stocks. For instance, the iShares Software ETF  (IGV)  fell 5.2%, and “meme” stocks GameStop  (GME) , AMC Entertainment  (AMC) , and Bed Bath & Beyond  (BBBY)  collapsed by 17%, 22%, and 62%.

The declines likely have you wondering how bad it could get. Of course, everybody’s crystal ball is foggy this year, but it’s important to remember pullbacks come in many shapes and sizes. It doesn’t have to be a straight line down, and the recent decline doesn’t guarantee we will retest or undercut June’s lows.

In “Correcting Need Not Mean Collapsing,” Top Stocks Helene Meisler reinforces this point, highlighting the action between 2000 and 2002 as an example. She writes,

“I want to take a minute to look at the chart of the S&P from 2000 to April 2002. Let me begin by noting I am not a big fan of analog charts (they always seem to end with a 1929-style crash when folks do them!) but patterns to repeat…Look at the decline in the S&P from the summer of 2000 until the spring of 2001. It culminated in a little double bottom that gave way to a rally. Then we had a big slide into 9/11 and we got a good low and rallied again. But look what happened after that rally had gone up about 20%: It stalled out. And it went sideways for five or six months…That sideways move in 2001 was around a 10% band. In hindsight, I view it as the market trying to figure out what it ought to do going forward.”

Chart2-082422

The market’s behavior in Meisler’s analog is similar to this year. She writes, “Now look at today’s market. We had a decline off the high, a double bottom that gave way to a rally, and a side into a low. Then we rallied.”

Chart1-082422

Of course, there’s no telling what happens this time, but Meisler’s point isn’t that the recent action will play out identically to the Internet bust, a period that also followed sky-high valuations and speculation. Instead, it’s to reinforce that investors need to be ready for anything, including a sideways “churn” that leaves bulls and bears disappointed.

Back to Meisler:

“I think the market corrects now, but I am calling it volatility because I don’t think we are heading right back down. I think we are going to go through a period of time where the market tries to figure out if things are bad or ... not as bad as they sound.”

If the market decides things are “bad,” then Action Alerts PLUS Co-Portfolio Manager Bob Lang thinks the next lower level of support exists near 4,100 on the S&P 500. He writes:

“If we do break that 4,100 level in the S&P 500, we do have some targets below at about 4,070, then about 4,000 ultimately. 3,973 comes into play at the 50-day moving average. Of course, that's rising every single day by a few points. So by the time we get to it, it might actually be higher than that 3,973. But that's going to be an important level to see if buyers can pick up the pace.”

The Smart Play

The dip this past week has filled a gap in the S&P 500 from August 10th near 4,137 (the high of August 9th). Coincidentally, that gap fill was slightly below the 21-day moving average. Since we’ve slipped through the 21-DMA, it’s become minor resistance worth watching.

If we hold and recapture the 21-DMA, it would be good news. However, the 200-DMA continues to trend lower, so it now represents strong resistance, only about 3.5% higher than the S&P 500 is trading at noontime today. That’s not a lot of reward for the risk of buying, especially since voting members of the Federal Reserve could say something hawkish at their annual meeting at Jackson Hole between August 25th to August 28th.

The recent rally was predicated on thinking worsening economic conditions could force the Fed to pause sooner rather than later. We certainly got bad news this week. The flash Purchasing Managers' Index suggests U.S. economic activity worsened in August from July, and the data is similar or worse overseas. In Germany, the Bundesbank recently warned a recession is increasingly likely even as inflation nears 10%.

The “upside” argument that could emerge from the Fed meeting this week is if Chairman Powell suggests a tapering in the size of future rate hikes. The past two increases were 0.75%. However, the CME’s FedWatch tool is currently tilting the odds toward a smaller 0.50% increase in September. If Powell suggests that’s the route they’ll take, it will support thinking the Fed may pause, giving them time to evaluate the impact of this year’s decisions.

Alternatively, the downside argument would be that Powell stays firmly hawkish, avoiding dovish comments that might increase the likelihood that less severe hikes are on the horizon. If so, recessionary worry is likely to grow, increasing the chances of a retest of June’s low.

We should also remember September is a notoriously tough month. According to the Stock Trader’s Almanac, September is historically the worst performing month for major indexes of the year, with the S&P 500 and NASDAQ returning -0.4% and -0.8%, respectively, in mid-term Election years.

Nevertheless, the S&P 500’s decline has put it in my first line of support. I’m not buying the index, but I am adding to some individual stocks, including recessionary stocks in healthcare and early-cycle ideas in industrials, such as infrastructure plays, and technology, including solar and EV-related plays, including suppliers.

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