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The third quarter was true "a tale of two eighths."  It was a clear dichotomy. The market staged what turned out to be a bear market rally throughout July and the first two weeks of August. Then it was as if somebody blew a whistle. The next six weeks saw the bear return with a vengeance. The question now is whether the market is now oversold and ready for a rebound in the November through mid-April period which is traditionally stronger for stocks. 

On a quarterly basis, I provide analysis focusing on the ETF reports on ValuEngine that follow market benchmarks. The data on these funds provide a side benefit in writing market analyses for each major US equity market segment. They are windows to implicit forecasts for 3-, 6- and 12-month forecasts VE models are making for each broad and specialty benchmark’s ETF portfolio. The ratings and projections combine bottom-up constituent analysis with analyses of the historical price movements of the ETF in different market environments.  

The benchmark indexes and ETFs chosen for this feature are:

1. The S&P 500 Index representing US Large Cap, the ETF is iShares’ SPY;
2. The S&P 400 MidCap Index representing US MidCap; the ETF is SPDR’s MDY;
3. The Russell 2000 Index representing US Small Cap; the ETF is iShares’ IWM
4. The Russell 1000 Large Cap Growth Index; the ETF is iShares’ IWF;
5. The Russell 1000 Large Cap Value Index; the ETF is iShares’ IWD;
6. The Nasdaq-100, constructed as an index using the top 100 non-financial stocks with primary listing on the Nasdaq, but now regarded as the premier US Big Tech Index; the ETF is Invesco QQQ.

The Following chart tracks the dichotomy of price returns between the first half of the quarter and the second half.

Somewhat surprisingly, small cap stocks and mid cap stocks as represented by their respective ETFs held up during the quarter than the four indexes representing various segments of large cap stocks.  The ETF for small cap stocks, IWM, was also the most robust during the rally period and held onto more of its gains during the August 15 – September 30 market collapse than any of the other five ETFs to register the smallest loss for the quarter.  In contrast, large-cap value stocks, as measured by IWD, lagged the other five ETFs by quite a bit during the July through mid-August rally. Thus, even though IWD had the least severe loss during the rest of the 3^rd quarter, it wound up as the biggest loser for the full quarter. On balance, large-cap value was not the place to be during the 3^rd quarter of 2022.  Similarly, even though QQQ suffered the worst carnage in the second half of the 3^rd quarter, the fact that it had previously led the group on the way up resulted in a lower decline in the 3^rd quarter for QQQ than SPY.

That’s what happened in the 3^rd quarter.  What could happen next?  For pondering that question, let’s look at the data summary table below.  All data are as of Oct. 14, 2022.

In order to frame our forecasts, let’s look at the ValuEngine ranking summarizing our models’ views on the expected price appreciation of SPY, the SPDR (“spider”) based on the S&P 500 Index. Given its bellwether status as the market’s proxy, a rating of 3 (neutral) is the norm for SPY. The ValuEngine market forecasts for SPY – and thus the S&P 500 - will vary from negative to positive depending on our models’ assessments of the current environment. 

Focusing on the S&P 500 column in the three rows containing our forecasts, our models expect the market to navigate the next three to six months in positive territory. After that, however, between mid-April and mid-October, our models forecast that the S&P 500 will relinquish those price gains and a bit more. 

Are there segments of the market for which the ValuEngine models have a more positive outlook? Yes, the two large cap growth-oriented ETFs, Russell Large Cap Growth, IWF, and Nasdaq-100, QQQ both get ValuEngine’s second-highest rating of 4 (attractive) for an upcoming performance. Of the two, IWF gets our highest forecast targets across the board and is the only one of the six benchmarks ETFs to have a positive forecast target for one-year-ahead performance. 

In contrast, the S&P MidCap ETF, MDY, held up best during the past three-month and six-month declines but is not expected to perform as well as the other benchmark ETFs going forward.  Its rating is 2 (below average) and its return targets for the next 3-, 6-, and 12-month periods are our second lowest across the board. IWD, the Russell 1000 Value ETF, also rated 2, receives our lowest return targets.     

On a valuation basis, the small cap segment ETF, IWM, looks unusually attractive on a price-to-book ratio basis.  It also has the highest percentage of undervalued companies, 73%, according to our valuation models. Moreover, three of the stocks in its top ten weightings are rated 4 (attractive) by ValuEngine. These include Shockwave Medical (SWAV); Chart Industries (GTLS); and Karuna Therapeutic (KRTX). 

In general, a little over 62% of ValuEngine stocks are deemed undervalued by our valuation model as compared with just below 40% at the beginning of the year. Therefore a 22% decline in SPY has been enough to transform a market with more than 60% overvalued to one that has the same proportion of stock now undervalued relative to intrinsic value. This can be thought of as analogous from a market being overbought to one that is now oversold. This interpretation would be consistent with the positive three- and six-month forecasts for SPY and the other benchmark ETFs. Repeating information I have frequently given in this column, if you decide to buy new shares of an ETF that follows the S&P 500, consider strongly buying VOO from Vanguard rather than SPY. A higher fee and a less efficient management structure combine to give SPY investors an average of 0.125% lower rate of return for holding an identical portfolio. If not VOO, our highest-rated ETF, IWF, tracking the large-cap growth market is a fairly equivalent substitute. Its correlation with VOO is about 0.99.

Will this optimistic forecast be enough for buy-and-hold investors to recapture a significant percentage of account balance declines already caused by the current bear market? Historically, dating back to 1926, July is the third strongest month for the market and September was the weakest. This year's numbers followed that history as if they were on steroids. Although January hasn't fared particularly well during the past ten years, in the longer term, it's been the second best, recently falling a bit behind December. November and March are also good months relative to May, June, and September. Our signals have now shifted to being guardedly optimistic for the next six months. 

Given the nine-month bear market, here is another fact to consider. Many investors may now be underweighted by more than 10% in equities relative to their strategic allocation. Today may be an opportune time to rebalance, shifting the money in alternative asset classes back to stocks. As per usual, only time will tell. 

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