Key Questions: Has the Stock Market Bottomed?
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The answer is seldom clear in real time, but it may be wise to fret less about what could go wrong, and instead ask: “What could go right?”
The strength of the recent market rally has caused investors to ask a serious question: Is this just a bear market bounce, or has the stock market bottomed and a new bull market begun? This is a difficult question to answer in real time, especially when you are looking only at price action. After all, if you are looking only at price action, both bear market rallies and new bull markets appear almost identical.
In both instances, bearish narrative is dominant, whether a hawkish Federal Reserve (the Fed), global geopolitics, inflation, economic weakness, declining corporate earnings, etc. No matter the topic du jour, it is taken as given by most market participants. The relentless negative narrative drives investor sentiment to move to an extreme level of bearishness. It is from these one-sided trading conditions that bounces emerge.
So, how do you distinguish between violent bear market bounces that are destined to fail and durable market bottoms that establish the base for a new bull market?
In a word: momentum.
Three Distinguishing Characteristics
New bull markets are notably different from bear market rallies via the presence of momentum. Luckily for investors, we have many tools to help identify momentum – three in particular that do an excellent job of helping to signal moves that investors do not want to miss.
First, we look for the percent of S&P 500 Index constituents trading at a new high for the last month to reach 53% or more. This is what many market watchers call an indication of “thrust.”
Secondly, we look to measure the amount of participation in a market rally. To gauge this, we look at the percentage of Russell 3000 Index constituents advancing over a rolling 10-day window. We want to see this move to a bullish extreme, signifying broad-based participation.
Finally, we like to see the number of S&P 500 constituents trading above their 20-day moving average reach extreme levels (more than 92%), signifying that the strength is both broad-based and persistent.
Why do we pay attention to what many see as random numbers? Simply put, each of these indicators has stood the test of time by proving to be a statistically significant and robust predictor of 12-month forward returns for the S&P 500. In fact, when all three of these tools are present at the same time, the signal is even stronger.
"The" Bottom? It Is Complicated
What are these indicators saying today? The first two indicators turned bullish in unison on July 28, with the final signal falling into place on August 12. So, given this, “the” bottom is in and investors should be outright bullish, right? Maybe. As always, the answer is more complicated.
Clearly, the presence of momentum is different than any of the prior bear market rallies since the market peak in January 2022. We look for two additional items for confirmation: 1) leadership and 2) trend.
Market cycles typically experience a change in leadership. The stocks that led the way higher last cycle are replaced by new leaders, exhibiting new narratives. We have been watching leadership very closely during the current rally and the message is mixed. We have seen both consumer discretionary and “high beta” stocks lead since the most recent lows, both of which are good news for the bulls. However, utilities – a traditional defensive sector – have also been a relative strength leader, which is somewhat troubling. We would feel much better about calling a durable market low if the message from market leadership was clear instead of murky.
As for trend, it is always slow and the last piece to fall in place. Recently, the market failed to breach its downward sloping 200-day moving average, which we saw as a natural resting place for the current rally. More importantly, the market had also strung together a series of new 3- month highs, which is not something that typically occurs during bear market rallies.
On Friday, however, the market made a new 1-month low in reaction to Fed Chair Jay Powell’s hawkish speech at Jackson Hole, Wyoming. Once we have seen a burst of momentum confirmed by the three indicators discussed earlier and the market has made a series of 3-month highs, we typically do not see the market move to a new 1-month low. Moving to a new 1-month low with these momentum conditions in place has occurred twice in the data back to 1957, with the most recent instance being 1974.
The market did not go on to make new lows in this instance, instead successfully “retesting” the lows by forming a higher low. Maybe this is in the cards now? Time will tell.
Ultimately, trend change is confirmed by the market making a series of higher highs and higher lows. It may seem difficult to believe this outcome is likely with the relentless flow of negatives on the evening news and in the financial press. But we think investors should be asking themselves a different question: “With everyone so negative, what could go right for the market from here?”
We think the balance of the evidence still skews toward embracing the recent momentum signals and having an optimistic view of where the market will be 12 months from now, near-term volatility notwithstanding.
About Stephen Hoedt
Stephen Hoedt is responsible for the oversight of our internally-managed strategies, individual equity due diligence, equity trading, and both taxable and municipal fixed income due diligence with an emphasis on credit research. Within the Equity Research team he is responsible for coverage of Energy, Industrials, and Materials.
Prior to joining Key, Steve was the Industrials and Materials Analyst for the National City Corporation’s Private Client Group. He began his investment career in 1993 as an equity research analyst with responsibilities for the computer hardware and software industries.
Steve has been quoted in several publications including Barron’s and The Wall Street Journal, and has also appeared on CNBC and Bloomberg TV.