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  • The S&P 500 has rallied over 12% since mid-June, including a 9% gain in July.
  • Major indexes are entering resistance and short-term indicators are flashing overbought.
  • Defensive baskets continue to provide substantial returns. 
  • Pullbacks over the coming months may offer investors an opportunity to accumulate early cycle stocks into weakness.

Investors got a good lesson in extrapolation risk in July. Following the worst first six-month performance in 52 years, stocks rocketed higher last month. The S&P 500 ETF, Russell 2000, and NASDAQ 100 ETF gained 9.2%, 10.6%, and 12.6%, respectively. The heavily beaten-up Semiconductor ETF (XSD) gained an eye-popping 20% last month.

The takeaway? Stocks don’t rise or fall in a straight line. Instead, stocks staircase up and down over time. Perhaps, that’s important to remember now, too, given the recent rally has lifted the S&P 500 to key resistance levels where sellers may emerge.

On Friday, Top Stocks Helene Meisler said her oscillator measuring net advances to declines was signaling short-term overbought.

Today, Meisler writes in “Upside Momentum Is Slowing,” that “For the last year, pre-dating the November high, every overbought reading has given us some sort of pullback [emphasis mine] except the overbought reading in early October, So if this overbought condition does not produce a pullback it will be a change in the character of the market.”

A character change would be welcome, but investors shouldn’t ignore the recent sell-off record following overbought readings.

Meisler also discusses the McClellan Summation Index. She writes: “If we use the McClellan Summation Index we discover that while this particular indicator is heading up (bullish) and now over the zero line (bullish) it now requires a net differential of net negative 5,000 issues (that's advancers minus decliners on the NYSE) to halt the rise…each time we have gotten this extreme we've seen a dip/pullback [emphasis mine].”

The McClellan Summation index is a running total of the McClennan Oscillator, which also measures advances to declines. Its recent track record offers another reason to approach this market cautiously.

Meisler isn’t the only person thinking stocks could take a breather, either. 

Doug Kass has been net bullish on stocks since May. However, the title of his Real Money Pro daily trading diary entry today was “Too Much Too Fast: It's Time to Reduce Long Exposure.”

The TL;DR version of Kass's bullish stance has been that too many investors had become too pessimistic, suggesting markets would reward folks who took a contrarian bullish point of view.

However, today, he writes, “Now is not the time to add risk... as the opportunity set of six weeks ago is no longer available.” He continues, “During the month of July the equity markets have exhibited the strongest gains since November, 2020 - I frankly did not expect the rally to be as violent to the upside. To justify buying today means that one expects a new Bull Market leg - something I remain dubious of.”

Kass outlines a slate of reasons investors may want to tap the brakes. Here’s a sampling of them, followed by my thoughts:

  • ”Given the easing of financial conditions since Powell's comments, I expect other Fed Presidents will push back the notion of a soft pivot in the day(s)/weeks ahead.”

Powell’s business-as-usual approach during his post-game comments (following last week’s rate hike) prompted many to hope the Fed may pause soon to see how its rapid pace of hikes this year is impacting the economy. The thinking that a friendlier Fed is on the horizon helped fuel animal spirits, but it wouldn’t shock Kass if Fed members walked back this enthusiasm in upcoming speeches. If so, reminders that inflation is too hot and requires more hikes to cool it may quell investors’ bullishness.

  • “ Structural headwinds to lower inflation remain - wages, rents and the price of durable goods.”

Indeed, wages are “sticky.” They’re certainly not transitory (absent lay-offs). Furthermore, while we’ve seen a retreat from peak prices in many commodities, they’re still up year-over-year, so they either need to fall more, or they’ll remain a headwind until they anniversary increases from last fall and this spring. Remember, the United States Oil Fund ETF USO touched $43 last August. Even after its sell-off, it’s still trading above $73. So, companies still face a double whammy of higher wages and input costs, squeezing margin. Meanwhile, because inflation is still outpacing wages, consumer budgets are still impaired, causing personal savings rates to dip and credit card balances to climb.

  • “Investor sentiment so dour five weeks ago is now elevated. Strength is being bought compared to avoiding weakness earlier as shorts have been massacred and forced to cover.”

Bear markets are born from short-covering. The bearish sentiment was extraordinarily high at the low in mid-May and mid-June, providing a spark for a bear market rally. Arguably, sentiment is still tilted bearish, but it’s not nearly as negative. This change in sentiment suggests that “easy money” has been made, and the market needs to prove itself from here.

As Kass notes, “The S&P oscillator is near 8% - way overbought - after being deeply negative in June. Many of the fugazzis in the business media who were deeply negative weeks ago are now positive, seemingly losing their memory of previous expectations.”

  • “Valuations have reset higher, quickly reversing the previous lower valuation opportunities.”

The recent rally in stocks is coinciding with lower third-quarter earnings growth expectations. As a result, the market’s P/E ratio doesn’t look nearly as enticing as it did a month ago. 

Stephen Guilfoyle notes in his Morning Recon column today, “current quarter (Q3) expectations in the aggregate, have dropped to earnings growth of 6.7% on revenue growth of 9.4. This is down from earnings growth of 9.2% on revenue growth of 9.8%. Can you say margin compression? This is all as full year (CY 2022) expectations have dropped to earnings growth of 8.9% on revenue growth of 10.7% from earnings growth of 9.8% on revenue growth of 10.8%.” 

As a result, the S&P 500 is trading at 17.1 times forward earnings estimates, which aligns with the 10-year average P/E. Stocks aren’t as big a bargain as they were a month ago.

The Smart Play

So far, short-covering has carried the rally baton. If this rally is to mature, however, the baton needs to get passed to institutional buyers. Unfortunately, it’s unclear if institutions are willing to accept the handoff.

For now, active investors should continue focusing on defensive, recessionary baskets like healthcare. These groups have performed very well since June's low. For example, the SPDR Healthcare ETF  (XLV)  has returned an impressive 11%. Meanwhile, the IShares US Healthcare Providers ETF  (IHF)  gained 15.4%, and the SPDR Utilities ETF  (XLU)  gained 16%, both of which outperformed the S&P 500’s 12.6% return.

Historically, it pays to sell growth stocks in the first half and buy them on sale in the second half of a bear market. I suspect we’re closer to the second half at this point.

Since stocks don’t travel in a straight line, we could see sellers emerge, particularly given the next two months are notoriously poor performers. If so, investors could get multiple chances to buy stocks on sale through early October. Although we have work to do on the economic front and everyone’s crystal ball is foggy, I suspect 2023 will be kinder to investors than 2022, making this a good time to add early-cycle growth stocks to watch lists.

If you’re a long-term investor and haven’t yet increased your monthly contributions to your workplace retirement plan, there’s still time to take advantage of the bear market. Although stocks have risen notably in the past month, we’re still only at the same levels we were in May, and the S&P 500 and NASDAQ are still down significantly year to date. Moreover, increasing the amount you contribute to an index fund during a bear market boosts the number of shares you own and lowers your average cost, putting you in the best position to benefit from the next bull market when it emerges.

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