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  • The market indexes held key support and have traded up this week.
  • Sentiment readings remain mostly supportive, but we're still in a bear market.
  • It's a good time to search for individual stocks that bottomed in May and have been outperforming recently.

After a disappointing but expected retreat, stocks found their footing near critical support levels this week. For instance, the S&P 500 tested support near 3,900 on three consecutive days, including a slight undercut on the 6th to 3,887. Since then, the S&P 500 is up 3.7%, and the tech-heavy NASDAQ has returned 4.6%.

That’s a nice bounce, but it’s hard for anyone other than the most nimble of us to get too excited about it. Why? Because bear markets are notorious for rapid, short-covering inspired run-ups that lose their luster at resistance and sell-off. Recall that less than one month ago, the S&P 500 was 7% higher and flirting with its downtrending 200-DMA.

Nevertheless, we stare at charts of major indexes, wondering, “was that the bottom?” Unfortunately, “the" bottom is only identifiable in hindsight. So, this was "a" bottom, but "the" bottom? Well, we won't know that for a while.

Can stocks keep rallying?

On the positive side of the ledger, the S&P 500 made a higher low after multiple days of testing support. That’s encouraging. After the June low, we rallied and pulled back in July to a higher low, and this recent retreat stopped above the July low, so we’ve strung together a couple of higher lows now. Again, encouraging.

Many individual stocks have put in higher lows since the bottom in May, so that’s encouraging too. Typically, individual stocks bottom before the market, and the market bottoms before the economy. Therefore, we can still argue individual stocks have been showing signs of accumulation since May and that the market is playing catch up.

However, there’s a lot of overhead supply, and that’s discouraging. The rally has once again pushed the S&P to its downtrending 50-DMA, and the downtrending 21-DMA looms above near 4,111, less than 2% above where the index traded this morning. That’s not a lot of reward for the risk of rolling over again.

Undoubtedly, some are trapped in stocks up to the 200-DMA and itching to “get out flat.” Will their selling stocks dwarf buying because of short covering? If computer-based sell programs kick in at key levels (like they did mid-August) and institutions remain cautious (getting redemption letters by the truckload), another wave down later this month wouldn’t be shocking.

It could be that sentiment is what determines what happens next. This year, folks have willingly believed in bottoms, quickly covering and buying risk to profit. However, “the” bottom usually occurs when folks are more skeptical, doubtful, exhausted, and fighting the rally as it climbs. For instance, consider how many argued against the rally during COVID, convinced that plummeting GDP from global lockdowns would trump Fed easing, causing stocks to retreat back to their March 2020 low.

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Survey says?

In “The Market Squeezes Some Air Out of the Pessimism Bubble,” Top Stocks Helene Meisler checks in with her favorite sentiment readings for clues. She writes: 

“We saw the first inkling of change with the International Securities Exchange Call/Put ratio chiming in with a reading over 1.0, which was the first such reading in nine days. The CBOE's put/call ratio had its first reading under 1.0 in nine days, as well. So it's an inkling of change or perhaps more like an acceptance that we're oversold enough to rally.”

The call/put and put/call ratio are contrary indicators for spotting inflection points at extremes. For example, when the put/call ratio is above 1.20, it can indicate that investors are so nervous that they’re avoiding the long side and buying puts to protect themselves from the carnage. Last week, the CBOE put/call ratio eclipsed 1.20. As Meisler points out, that’s no longer the case.

However, Meisler uses a 10-day moving average of put/call to smooth out daily volatility. She writes, "the 10-day moving average of the equity put/call ratio is now kissing the May and June peaks. It hasn't turned down yet; I expect it to do so next week.”

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Other sentiment indicators also support bulls. Meisler writes,

“The American Association of Individual Investors (AAII) did not disappoint in that they turned solidly bearish this week with bulls back in the teens and bears in the 50s. The National Association of Active Investment Managers (NAAIM) saw a build-up in bearishness, as well. These folks had their exposure to the market at a smidgen over 70 about a month ago, and now their exposure resides at 27. The May and June lows were 20. So this, too, says exposure to the market is low.”

Again, these are contrary tools. When respondents to these surveys are overly bearish, it can suggest stocks are ready to rally. In this week’s AAII report, bullish responses fell to 18.1%, the first sub-20% reading in nine weeks, while bearishness clocked in at 53.3%, an 11-week high. Overall, that puts us back to sentiment in the ballpark of what we saw near June’s low. As for NAAIM, a reading of 27 is the 3rd-lowest this year, trailing only the May and June lows.

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So, does that mean there’s more gas in the tank for this rally to continue? Meisler says:

 “Are we still oversold? I think yes. I use the 10-day moving average of net breadth as my guide for the Overbought/Oversold Oscillator, and beginning Monday, we have seven-straight days of negative breadth to drop. That doesn't mean we will be up every day (unlikely), but it ought to keep some momentum heading upward for the time being.”

The Smart Play

Most stocks trade in the direction of the S&P 500, so understanding the likely path of the index helps improve win rates. Currently, the market is a bit in “no-man’s” land, above support levels but entering resistance levels. For this reason, investors should remain cautious.

That said, it’s not a bad time to selectively hunt for individual stocks. As I mentioned, many stocks put in lows in May and haven’t looked back. For example, solar stocks, such as Enphase  (ENPH) , have performed remarkably well, supported by demand because of high fossil fuel prices and regulatory incentives. The story is similar for individual stocks targeting infrastructure spending, such as Quanta Services  (PWR) . There’s also strength in healthcare growth stocks, such as Lantheus  (LNTH) , Shockwave Medical  (SWAV) , and Evolent Health  (EVH) . And some retailers, including Ulta Beauty  (ULTA)  and BJ's Wholesale  (BJ) , have also demonstrated strong relative strength this summer. A couple of examples in technology include Palo Alto Networks  (PANW)  and Sanmina  (SANM) , neither of which retested their lows in May.

In short, a surprisingly large number of stocks are performing well, given how the index has struggled.

I’ve previously mentioned that having a mental framework can help you tilt positively or negatively. It pays to sell the first half of a bear market and buy the second half. I’m in the second half camp, so I’m tilting net long by focusing on recessionary and early-cycle stocks showing leadership. I expect 2023 will be friendlier to investors than 2022, keeping with past pre-Presidential Election years.

Remember, though, the next bull market’s big winners aren’t likely the same as the last bull market. So, while it’s a good time to screen for stocks to buy on pullbacks, you still want to play defensively because it’s still a bear market. So, for example, limit exposure to leverage, high beta stocks, and high valuation stocks; use stop losses below key technical chart levels; and opportunistically short stocks at resistance until there's more clarity.

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