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Where do stocks go from here?

The summer rally has helped improve the outlook for stocks after a tough first half of the year, but both the bullish and bearish cases have powerful arguments supporting them.

Source: Bloomberg

​​Global stocks bounceback from July lows

The past month has seen global equity markets stage an impressive recovery.

As of mid-June, the MSCI world index was down by almost 25% for the year so far. The rally from the lows of the year has witnessed a recovery of 15%, resulting in 50% of the losses for the year being recouped. This does not mean that the bear market for this year is over.

Inflation, rising interest rates and slowing growth mean that a recession that hits earnings is still a definite possibility. But for the moment there are signs that stocks, led by US indices, might have a way out of the doom and gloom.

S&P 500 breadth rebound provides hope

The current bounce on the S&P 500 has resulted in a sea-change in breadth readings. Rallies in March/April and in May had seen the percentage of stocks above their 50-day moving average rise from around 25% to 65%, and from 20% to 45% respectively.

But the surge over the last month has seen the reading go from a ‘washout’ low of around 7% to a remarkable 90%. This is a dramatic turnaround, and suggests that stocks have put in a floor on their declines, at least for the time being.

Previous bear markets in 2001 and 2008 witnessed big rebounds, but none of them saw breadth rebound in the way that it has over the last month.

50DMA breadth chart Source:

As the chart below shows, these high breadth readings usually occur in strong uptrends, with returns for the S&P 500 in the following year averaging at least 20%.

Breadth uptrends Source: Carson,

Inflation concerns fading

The recession fears of the first half of 2022 were driven in a significant way by the surge in oil prices, along with other commodities.

Oil price chart Source: ProRealTime

But since June the price of oil has fallen sharply, and it is not alone among commodity prices.

Copper, wheat, lumber, corn and nickel prices have all dropped over the past three months, and with US consumer price index (CPI) growth easing in recent readings as investors are beginning to hope that inflationary pressures will drop, prompting the Federal Reserve (Fed) to at least ease off its pace of hiking, perhaps moving back to 50 basis point (bps) rate increases from the 75 basis points of the past few meetings.

Earnings outlook crucial

Perhaps the most important element for the next few months will be the third- and fourth-quarter (Q4) earnings seasons.

Q2 saw earnings generally beat the (lowered) expectations held by analysts, and relatively rosy outlooks issued. But Q3 and Q4 expectations are still relatively elevated, and excluding the stellar performance from the energy sector, the S&P 500 still reported a year-on-year (YoY) decline of 4% for earnings.

While slower inflation growth will help consumer spending hold up, investors will fret that this will feed through too late to help earnings for Q3 at least.

Having rallied sharply from their lows, stocks are no longer pricing in so much bad news as was the case back in early July. This leaves them less well-placed for a fresh fall in earnings when Q3 reporting season begins.

Seasonality risks ahead

Historically, markets tend to run into problems in August and September. The historical pattern for the S&P 500 shows a period of weakness from the end of August until the beginning of October, when the traditional Q4 rally begins to start.

In addition, mid-term years such as this one usually witness a fresh drop for the S&P 500 during the months of August and September. From there the picture brightens considerably, with the usual Q4 rally augmented by further gains into years three and four of the presidential cycle.

Presidential cycle chart Source: IG

Market outlook evenly balanced

While the broad expectation in recent weeks had been for a fresh move to the downside for stocks, the strength of the rally and signs of easing inflation have bolstered the case that the market has seen its lows for the year.

But there are still powerful arguments on the other side of the hill, and it is by no means certain that we will see further strength from here. And it is important to remember, whichever view you take, to make sure that the correct risk management is in place to help you navigate the coming months.

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