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Why the stock market might give back its April gains

Joe Fahmy
·Contributor
·4 min read
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In my recent article from early April, I said that “Over the next four to six weeks, we could see a rally in stocks that takes the Nasdaq Composite back to new highs and the S&P 500 to 4200.”

The good news is that the indexes reached those targets. The bad news is that April was a difficult month for many growth stocks. From here, one of two things should happen. Either growth stocks stabilize, resume higher, and lift the rest of the market with it, or the recent weakness beneath the surface will bring down the overall market. I’m leaning towards the latter. The market will give back its April gains over the next two months for the following reasons.

1) I’ve always believed that it’s not the news, but the market’s reaction to the news that is more important. Over the last two weeks, many Mega Cap growth stocks announced outstanding earnings and still sold off after their reports. If you hypothetically had the earnings reports of Amazon (AMZN), Apple (AAPL), and Microsoft (MSFT) in advance, you never would have imagined that they would all close negative the next day. This reaction showed me that big institutions are currently selling into strength.

2) May and June (especially the second half of June) tend to be challenging months for the market. After the first week of May, approximately 80% of S&P 500 companies will have reported their earnings. The news cycle will then shift away from fundamentals to politics, interest rates, and any geopolitical concerns. Speaking of interest rates, as the economy slowly gets back to normal, it wouldn’t surprise me to see the 10-year yield return to its levels from January 2020 (around 1.8%-2.0%). If this happens, it will lead to further compression in the multiples of growth stocks.

3) The IRS deadline for filing tax returns was extended this year to May 17. We will likely see tax selling prior to this because 2020 was a strong year for the markets, and many people will have capital gains taxes to pay by this date. On a related note, the new administration seems determined to raise taxes, specifically capital gains taxes. I don’t believe they will get any of these new proposals approved, but the continuous headlines could keep some pressure on the market over the near-term.

4) The S&P 500 (^GSPC) historically averages a 10% return per year. So far this year, it is up over 11%. It wouldn’t be unreasonable to see a normal correction or some technical digestion before heading higher later in the year. Also, since 1980, the average intra-year correction is -14.3%. 

S&P 500 intra-year declines v. calendar year returns
S&P 500 intra-year declines v. calendar year returns

5) A few sentiment measures are showing high levels of bullishness. For example, the latest NAAIM Exposure Index, which measures exposure by active investment managers, is at its highest level in over two months. Any minor pullback would shake out some of this excess bullishness, as investors are still quick to rush out the door when the market starts to drop.

I would like to stress that I am not turning bearish, just cautious over the near-term. There are many strong factors in the market’s favor from now until year-end. The economy continues to return to normal, earnings are improving, and the Fed is still providing a tremendous backdrop for the market. They are not raising rates anytime soon, nor are they slowing down or “tapering” their bond purchases. This will continue to provide an equity friendly environment into year-end. I simply think over the next two months, a 4%-6% pullback would be normal and nothing out of the ordinary. The best way to describe my current stance is short-term cautious but still longer-term bullish. 

Chart provided by MarketSmith.
Chart provided by MarketSmith.

This is where market participants need to make decisions based on their own timeframe and investment objectives. If you have a longer-term horizon, stick with the trend, and accept some normal corrections along the way. If you are a shorter-term trader, using lighter positions could help reduce volatility, especially if growth stocks correct greater than the market. Either way, if we see a pullback over the next two months, it will set up some strong opportunities into year-end. Good luck!

I can be reached at: jfahmy@zorcapital.com

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