Market Correction Doesn't Deter Investor Bullishness

By Lance Roberts & Michael Lebowitz of Real Investment Advice

Saturday, July 27, 2024 10:53 PM EDT

Rationalizing The Chaos

Previously, we noted that a pullback was needed to resolve the market’s overbought and extended conditions. As expected, the correction accelerated this past week as the 20-DMA failed to hold.

“However, if the 20-DMA fails, as in early April, the 50-DMA becomes the next logical support, with the 100-DMA close behind. Such would encompass another 3-5% correction.“

This past week, that pullback continued with the market breaking through the 20-DMA and testing the 50-DMA on Thursday. As we noted in Friday’s Daily Market Commentary (Subscribe for free daily pre-market email):

“Whenever there is a market decline, we humans must try to rationalize the ‘chaos’ by assigning a reason to it. The most recent rationalization is that the ‘AI trade’ is dead. As noted by the better-than-expected revenue and earnings from Google (GOOG), most earnings growth comes from the largest companies. As such, we seriously doubt that managers will abandon these companies anytime soon. Furthermore, given that hedge funds need to move large amounts of capital at a time, these large-cap companies are the only companies that provide the needed liquidity.

However, every time these ‘Mega-Cap’ companies pull back, the media assigns a new rationale for why it is happening. The reality is that these companies have posted stellar returns this year, and a bit of profit-taking is unsurprising, just as we have seen at each previous market peak over the last two years. The chart below compares the darlings of the ‘AI trade,’ Apple (AAPL), Microsoft (MSFT), Google (GOOG), and Amazon (AMZN) to the S&P 500 index. (I would have included NVDA, but it has rallied so much that it skews the chart too much.)

When the S&P 500 index advances or declines, there is a high price correlation with the ‘Mega-Cap’ stocks. That correlation should be unsurprising because they make up ~35% of the index. The crucial point is that the current correction is likely just like every other correction we have seen over the last few years. It is highly likely that when this current corrective process concludes, large-cap stocks will once again resume their leadership.“

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Our need to “rationalize the chaos” can lead us to make poor investment decisions. So far, the correction remains quite ordinary, with volatility remaining quite suppressed. Furthermore, the market reclaimed and held the 50-DMA on Friday with an encouraging broad market rally. However, while the markets are oversold enough for a reflexive bounce, the current correction process is likely incomplete. Moreover, the MACD “sell signal” also suggests that the current upside remains limited.

It is quite likely that any short-term, reflexive rally will fail during this corrective process. For now, use rallies to rebalance portfolios and reduce risk as needed. Our only concern is that with investors remaining very bullish despite the recent pullback, a further correction is required to resolve that condition.

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Pullback Doesn’t Deter Investor Bullishness

The recent pullback in large-capitalization stocks surprised investors and sent the media scurrying to proclaim the “death of the A.I. bubble.” Such certainly seemed to be the case last week when hedge fund exposure to tech dropped sharply during the past two months. At the same time, hedge funds remained highly exposed to all other sectors, and the violent selling in the “Mag 7” sparked a burst in volatility, which prompted broader selling across the board. It was one of the sharpest rotations over the last decade.

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At the same time, it was one of portfolio managers’ most extensive de-grossing activities since 2022.

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Without looking at a market chart, you would assume that the markets just crashed. However, as shown, such is hardly the case, and since the October 2022 lows, the recent pullback remains very ordinary.

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Such is interesting because such a violent rotation should have also coincided with a sharp increase in market volatility. Yet, that did not occur, with volatility remaining suppressed within the longer-term downtrend.

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While the media has been quick to jump on the rotation as the “death of A.I.,” the “rumors of its death may be greatly exaggerated.” Such is particularly the case given that portfolio allocations and sentiment by both retail and professional investors remain aggressively bullish.

A Review Of The 2022 Market Lows

In October 2022, we discussed that extreme negative sentiment was likely the basis for the end of the correction that had started in January. To wit:

“The composite index below, combining retail and institutional investor sentiment, is extremely negative and typically marks short- to intermediate-term market bottoms.”

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At the time, the point of that discussion was not to let emotions dictate your investing. Every mainstream economist predicted a recession, market sentiment was bearish, and investors cut allocations sharply. Furthermore, the number of stocks with “bullish buy signals” had also hit extremely low levels. The bullish percent index suggested that stocks had seen rather extreme liquidations.

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As we noted then,

“When levels of negativity have reached or exceeded current levels, such has historically been associated with short- to intermediate-term market bottoms.”

Notably, those more extreme levels of negative sentiment have followed periods of record-level de-grossing. However, following the recent pullback, we see a very different market picture if we review those charts today.

Investors Remain Very Bullish

As shown, net bullish sentiment is no longer near lows but near peak market levels that have typically preceded corrections. Despite the recent pullback, sentiment barely budged.

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The same goes for the number of stocks on bullish buy signals. Given the pullback in large-cap stocks, seeing the index a bit lower is unsurprising. However, given the angst over the recent decline, you would have expected to see this index near previous market lows.

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Notably, the allocation to equities by both retail and professional investors remains exceptionally elevated. So, despite the market pullback over the last couple of weeks, bullish sentiment and positioning remain elevated. The slight reversal in positioning is unsurprising, given the pullback. Still, it comes off levels that have often preceded short—to intermediate-term market corrections rather than a continued bull market advance.

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We see that same point in the overall allocation and sentiment gauge below. Despite the correction, sentiment and allocations remain highly bullish and drastically different from the October 2022 lows.

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While the pullback and rotation over the last couple of weeks were extremely rapid, from a positioning and sentiment view, little has changed. The bullish momentum remains, and given the needs of large-cap portfolio managers, hedge funds, and pension funds, which need to allocate large sums of money, the large-cap flows will likely remain intact.

In other words, I would be cautious in assuming the A.I. trade is dead, at least for now.

Still A Function Of Earnings Growth

Lastly, and probably the most important, is that despite rumors to the contrary, the bulk of earnings growth is still coming from the largest companies.

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As discussed in last week’s newsletter:

“Small-cap companies are highly dependent on more robust economic activity. We see this issue by comparing the annual rate of change in the sentiment of the National Federation of Independent Business to that of Russell 2000. The current gap is likely unsustainable. Either the economy will improve markedly, boosting small business sentiment, or Russell will catch down to the sentiment. That is something worth paying attention to.”

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The problem is that virtually all measures, whether employment, manufacturing, or services, suggest slower economic growth. The RIA Economic Composite Index, which comprises more than 100 data points, does not suggest an economic rebound is afoot.

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Given the weak backdrop for economic growth, as the consumer is increasingly becoming financially impaired, as seen in rising delinquency rates, the ability of smaller companies to aggressively grow earnings remains suspect.

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Yes, the market is currently experiencing a normal corrective pullback. However, we doubt the narrative of a massive shift into the most economically sensitive areas of the market.

Like many other past pullbacks, we suspect this one will allow investors to add equity exposure. However, that opportunity may still be a few weeks away, so remain cautious for now.

Navigating The Pullback

As discussed over the last few months, we anticipate a 5-10% correction sometime this summer (between August and October). The more exuberant bullish sentiment and allocations need to reverse to some degree.

Are we beginning that corrective pullback now? Maybe. Unfortunately, we will only know if hindsight.

We agree that there are many reasons to be concerned about the current market. Therefore, as we have already done, we will use rallies to reduce equity exposure and hedge risks accordingly.

Move slowly. There is no rush to make dramatic changes. Doing anything in a moment of “panic” tends to be the wrong thing.
If you are overweight equities, DO NOT try to fully adjust your portfolio to your target allocation in one move. Individuals often feel like they “must” do something. Think logically about where you want to be and use a rally to adjust to that level.
Begin by selling laggards and losers. These positions were dragging on performance as the market rose, they tend to lead on the way down.
Add to sectors or positions performing with or outperforming the broader market if you need risk exposure.
Move “stop-loss” levels up to recent lows for each position. Managing a portfolio without “stop-loss” levels is like driving with your eyes closed.
Be prepared to sell into the rally and reduce overall portfolio risk. You will sell many positions at a loss simply because you overpaid for them. Selling at a loss DOES NOT make you a loser. It just means you made a mistake.
If none of this makes sense, please consider hiring someone to manage your portfolio. It will be worth the additional expense over the long term.