September 18, 2020
Markets have shown signs of stabilizing after suffering a relatively sharp 7%, technology sector-led pullback earlier this month. After a tremendous rise entering September, stocks had become stretched on a short-term basis, and signs of increasing investor complacency were evident.

Indeed, the stock market’s rise from the March bottom was well ahead of all bull markets since 1950. Moreover, there had only been two pullbacks of more than 5% since the rebound began, versus the more typical three or four seen over the first nine months of prior bull markets. From a valuation standpoint, the S&P 500 had also reached a cycle high in early September, and signs of overcrowding in just a select group of technology stocks were apparent. During August, the technology sector jumped 12%, and the forward price-to-earnings (P/E) ratio for the group shot up from 25x to 29x over just one month. Moreover, the average stock continued to lag the headline index, as a few high-flying technology stocks outperformed.

The good news is that as a result of the corrective period, some of these excesses have moderated. As opposed to being well ahead of the trajectory of the 1982 and 2009 bull markets, as it had been prior to the setback, the current bull market is now more in line. Also, while still elevated, the S&P 500 is now less than 10% above its 200-day moving average, down from 16% near the beginning of this month. Frothy investor sentiment is also showing some signs of moderating. For example, after reaching the highest level since before the pandemic, the average recommended equity allocation by newsletter writers, based on the Hulbert Sentiment Index, has dropped significantly.

The S&P 500’s forward P/E has also reset to the lower end of the range it has traded in since early June, as a result of the price setback combined with a continued rise in company earnings estimates. Similarly, the technology sector’s forward P/E has unwound most of its August overshoot. The average stock’s relative performance has also improved, given the sharper pullback in the technology sector and rotation into other areas of the market.
Indeed, we are encouraged that economically-sensitive sectors are showing positive earnings momentum relative to defensive areas, consistent with our view of an economy in early expansion. Two of our favored sectors, consumer discretionary and materials, are among the areas showing the strongest near-term earnings strength, while profit trends in industrials are also improving.

Bottom Line

We view the market action over recent weeks as a healthy reset of the bull market trend. We still expect markets to remain choppy near term and volatility to pick up as we move closer to the election. However, the weight of the evidence in our work still suggests the primary market trend remains higher. Accordingly, we recommend investors stay aligned with this trend and for those investors underweight equities to view pullbacks as opportunities.

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