The S&P 500 Index closed at a record high on Wednesday, yet investors seem increasingly on edge with the VIX Index, a measure of implied volatility on the S&P 500, spiking nearly 40% week-to-date. We won’t bury the lead here, our answer to the title is simple: this could be the start of a correction, but we aren’t betting on a significant decline in the S&P 500 and here’s why.
First of all, it is important to remember that corrections are a normal part of investing and there are plenty of reasons why stocks could pull back here. Weak market internals, high valuations, and tendency for Year Two of a bull market to be difficult are three things that worry us.
However, we are comfortable with an overweight allocation to stocks versus bonds, and we are maintaining that view for the following reasons:
Reason 1: Longer-Term Trends Remain Strong
Breadth was historically weak on the S&P 500’s recent streak of record highs, and that fact has been well documented by LPL Research and others. However, breadth can be measured on multiple time horizons, and though the percent of stocks above their shorter-term 50-day moving average showed a historically weak reading for record highs (below 50% for the first time since December 1999), the percent of stocks above the longer-term 200-day moving average is still remarkably strong at more than 90%. And looking at the index itself, the 50-day moving average (orange line) has acted as strong support year to date. We also identify technical support levels based on recent index lows at 4164 and 4056 (green dash lines). Even a move to the lower support level would only represent a 7% correction from Wednesday’s high.
Reason 2: Most Vulnerable Groups Have Already Corrected
Much of the recent fear seems to have been pinned on the surging Delta variant of the COVID-19 virus, and the potential economic toll it might take. And to be fair, relative performance has reflected virus fears seen last year, with financials, industrials, and materials underperforming, and a rush back into “stay at home” growth stocks. This is much of the reason for the poor breadth readings. However, the flip-side of those poor breadth readings is that even if the S&P 500 starts to pull back, the stocks expected to do the worst in a scare have already corrected. We believe that to be the case for the financials sector, which has already reached an oversold reading based on the percent of stocks in the sector above their 50-day moving averages. When this reading falls near 20% and the sector is still in an uptrend, it has historically been a buying opportunity.
Reason 3: Bonds Are as Unattractive as Ever
Financials in particular have been impacted by falling interest rates, which we believe are poised to resume their longer-term trend higher. As shown in the chart below, the yield for the 10-year Treasury has significant support near 1.2%, and based on the RSI-14, a technical indicator (bottom panel), is the most oversold since March 9, 2020, its all-time low. Not only do lower yields mean lower expected returns for bonds, but we don’t buy the narrative that falling interest rates indicate the bond market is pricing in problems with the reopening. High-yield credit spreads remain the tightest we have seen since 2014, something we do not believe would be the case if investors were pricing in true disruptions to the economy.
Year 2 of the bull market is living up to its reputation for being difficult, but is also on track for delivering positive returns as it historically has. We expect that to be the case through the end of the year and are comfortable with our overweight equities recommendation.
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