Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.
EQ: The Dow eclipsed the 22,000 level this week, at least on an intraday basis. The S&P 500 is also about 1% away from the 2,500 thresholds. Could these milestone markers serve to propel the market higher or potentially trigger a digestion of gains?
Stovall: I think in the near term, it probably could actually end up being a bit of a resistance level, and trip up the stock market so that it does go through some sort of digestion of gains. Longer term, however, history says that because we have hit so many new all-time highs thus far this year, we have a very good chance of posting a positive performance in the remaining months. By longer term, I mean over the next five months or so.
I went back to World War II and looked at all those years that had a count of new highs equal to what we have this year, so at 29 or higher. There were seven other years that had even higher counts of year-to-date all-time highs through the end of July. In six of those seven, the market was higher 100% of the time in the remaining months and rose an average of 6.5%. Encouragingly, I also found that whenever the year had just even more than the average through July, it ended up with a more-than 4% gain for the rest of the year.
There’s only one fly in the ointment, and that is 1987 was among those seven times that we saw the count of all-time highs exceed that of July of this year. Of course, the infamous Black Monday in which the Dow crashed 22% in one day occurred on October 19, 1987.
EQ: In this week’s Sector Watch report, you noted that Q2 earnings have been coming in strong. We’re now about halfway through, but once reporting season is over, the market may be in search of a new catalyst in order to move higher. Is there anything on the horizon that could encourage bulls?
Stovall: Yes, I think some sort of agreement on a tax cut could end up being very helpful to the bulls, but I have a feeling that possibility is not coming in very clearly these days. It seems as if it’s going to be an uphill slog for the administration to be able to put forth a tax cut proposal, and at the same time, to then have the Democrats to be willing to accept it. So, unfortunately there are not a lot of catalysts that I see currently that could end up taking the place of better-than-expected earnings, which is definitely what we are getting for this second quarter.
Right now, it seems as if we’re going to see a 10% increase in year-over-year earnings versus the 6% that was anticipated at the beginning of the reporting period. So, I think we need to look very closely to see what else could end up supporting stocks. Maybe, as an example, it could be the lack of movement by the Fed.
EQ: As you’ve noted before in our interviews, momentum stocks may be the best play in this environment. That said, if momentum does decide to move against these stocks, how should investors respond?
Stovall: Well, if momentum does move against these stocks—because they have had such high momentum—they probably are going to get hit on the chin a lot harder than the non-momentum stocks in the near term. Yet, this strategy has historically done exceptionally well over the past 20 years. By focusing on the top 10% of the sub-industries in the S&P 1500, and by buying and holding them in equal proportion, then re-evaluating them every month, this technique has provided a compound rate of growth of 13.5% as compared with 6.4% for the S&P 1500.
Also, on an annual basis, this strategy has beaten the market seven out of every 10 years. Of course, there’s no guarantee that it’s going to work this time, and should we end up stumbling, then usually it’s the high momentum stocks that get smacked the greatest. However, I think because we will not be heading into a bear market when this digestion of gains has fully run its course, I see investors moving back into these higher growth momentum areas and resume the bull market all over again.
EQ: CFRA did, however, identify 15 sub-industries and their proxy stocks for investors to play the high-momentum groups. Were there any common themes in these groups?
Stovall: Not surprisingly, Technology has the greatest representation. Within the top 15 sub-industries, a third were Tech stocks. We had five sub-industries from the Tech sector, four sub-industries coming from Consumer Discretionary, two from Financials—you can add REITs as another Financials-type sub-industry—and we had three from Industrials. So, it’s really the cyclical side of the equation that’s holding up the best with Tech, Consumer Discretionary, Industrials and Financials.
So, the theme is that it’s bucking the trend of the sell in May mindset that usually takes hold from the end of April to the end of October. However, we are entering into the two most challenging months of the stock market, that being August and September, both of which have recorded average declines. September is even worse than August because the market has actually fallen 58% of the time in September, whereas its risen 54% of the time in August.