The Market Is Turning Positive: What Does This Mean for You?

Buyers jump back in

For the time being, the lesson is that buyers will jump in on drops to around the 10-week moving average, which means the market is sticking to its intermediate-term uptrend in textbook fashion.

Yesterday’s one-day, all-inclusive rebound resembles what we saw in late June following the Fed meeting – a quick drop to the 50-day average, then a one-day burst higher to make up most of the loss, followed by a half-percent follow-through gain.

It’s worth noting that the little gut check allowed the market to regroup and push higher, but it didn’t create escape velocity. It was about a 5% run up, followed by a 3% drop. It’s more of a toss-and-turn than a high-momentum levitation.

Stocks had to digest a huge yield surge, then a fast decline, sideways choppy summer, but ultimately a strong, low-volatility 30 percent full-year return, similar to the 2013 market, which was up a similar amount into July. This defines the best-case scenario, not the worst-case scenario.

The bounce action has saved the cyclical trade from losing its claim to market leadership. Energy, transportation, and banking are all reacting to washout-type conditions, with small-caps (which have a lot of ground to make up) outperforming again today.

Reasons to be cautious: The S&P 500 is still 1% below its all-time highs. Prior to the recent index hiccup, there were weeks of poor breadth, which can indicate a less-solid rally foundation. Seasonal turbulence has been the norm into and through August, particularly during the Jackson Hole Fed confab era. FWIW:

Too much emphasis is probably placed on relatively small movements in Treasury yields here – not every tick is closely calibrated to the real-time macroeconomic pulse. However, the upward trend in yields gives equity traders the confidence to increase risk exposures slightly.

With a more settled macro mindset, single-stock earnings reactions are gaining traction once more. Dissatisfaction with a stable, maturing Netflix that appears content to grow with the streaming pie and not much else. It’s not looking good for Disney if NFLX is de-rated, given that the market has rushed to assign an NFLX like valuation to Disney’s narrower streaming business. Chipotle being anointed into the Great Eternal American Brands portfolio alongside NKE, SBUX, and DIS, with the accompanying stubbornly rich valuation? That appears to be the case.

Market breadth is quite strong again, which is a plus, with roughly 90% of NYSE volume to the upside. With all-or-nothing systematic trading, we see a lot more extreme breadth readings these days, but two near-90 percent upside volume days in a row is a positive demand signal that should not be dismissed.

The VIX is falling, as it should, to below 19. Given seasonals/delta, the recent lows may be the floor, but the resumption of the slow summer grind should be reflected in lower vols. If it does not occur, it will complicate the bull story.

Economic recovery

The level from which the S&P500 bounced was near the 50-day moving average, which has served as consistent support – if not instant reversal – all year. As shown here, the majority of these pullbacks involved more than just a single touch-and-bounce off the 50-day moving average, with some churn and revisiting usually (but not always) involved.

So far, the Turnaround Tuesday rally has nearly, but not quite, reclaimed all of the ground lost the day before. This could be a classic “fill the gap” test of sellers’ and buyers’ resolve. Every long-lasting comeback begins with a gap-filling. Not every gap-fill results in a long-term recovery.

The already battered cyclicals and “beta” sectors that began rolling over in May and June were most primed for some relief and are unquestionably leading the rebound. Transports, energy, and industrials are all examples of small-cap stocks. Intuitive, but not decisive of the next step.

Why the shift in tone? Monday appeared to be a concentrated Covid-fear relapse and growth scare, encapsulated in Treasuries’ relentless rally. When yields rose off new multi-month lows this morning, it cleared the way for cyclical investors to buy on the cheap. Approximately half of the post-Covid yield surge was retraced. For months, it has been a trap to declare yields finally bottoming out, but today’s action relieves some of the pressure on the recovery trade.

The period of sideways action in the average stock as profit forecasts rise has significantly moderated valuations on the equal-weight S&P500. All else being equal, it reduces fundamental risk, particularly when compared to corporate bond yields and dividend/buyback flows.

The first 1% drop after a long period of calm – as we saw yesterday – is not usually a one-and-done event, but instead usually heralds more churn and chop in the days/weeks ahead. Still, when it comes to the depth/duration of pullbacks and the time required to resume a rally, this market has a better track record than the average.

The seasonal backdrop is less inviting. However, the history of years in which the S&P500 gained at least 15% in the first half predicts further gains by year’s end, even if there is often some backsliding along the way.

The Fear/Greed Index became much more concerned than one would expect given the S&P’s 3% drop, most likely as a result of bond dynamics and volatility measures. This is a net positive for stocks because it shows the bulls’ aggressiveness is under control.

Market breadth is very positive, roughly mirroring yesterday’s washout, with many new 52-week lows on the Nasdaq. We still have a more selective, indecisive, and less generous tape than we did a few months ago.

The VIX has dropped to 20, in sync with the S&P’s rise. A five-point drop from a high creates a spike on the chart, which some traders use as a buying signal. Still, the fact that the S&P is hovering near 20 and not quite above Friday’s close indicates that traders are not yet confident in the recovery.

Volatility is expected

“This is not the month to be a hero. “July is usually choppy,” Lee said.

Lee’s remarks came after the Dow Jones Industrial Average fell more than 700 points, marking its worst day since October of last year. Concerns about the economic recovery were heightened by an increase in Covid cases in the United States and the continued spread of the highly contagious delta variant.

Coronavirus cases also increased around July of last year, causing a “wobble” in the stock market, according to Lee. The strategist, who was known for correctly forecasting the stock market’s ups and downs during the pandemic, said investors are now witnessing a similar seasonal movement.

According to Lee, this month tends to bring turbulence for stocks, even outside of Covid concerns.

“Julys have never been great months for people to really make big profits, at least in my 30 years of doing research,” Lee said.

“When markets are strong in the first half, July tends to be pretty choppy, and I think that’s pretty textbook right now,” he added.

Lee emphasized that he does not believe Monday’s sell-off signals the end of the bull market and that stocks will return a double-digit return in the second half of 2021. However, in the short term, he warned investors to expect continued volatility.

“I think it’ll be tough for the next couple of weeks,” Lee predicted.