A Bull, or a Bear in a Bull Costume?

U.S. stocks are back in rally mode. The S&P 500 Index has jumped 25% since March 23, its strongest such gain since 1938. But is the rally sustainable?

Sentiment has turned on a dime, thanks to signs of the coronavirus “curve flattening.” Over the past week, we’ve seen some glimmers of hope that this crisis may be peaking in some areas, including slowing growth in U.S. confirmed cases. Investors believe they are finally seeing some light at the end of the tunnel.

However, history shows many bear markets go through a few bull market “head fakes” before finally reaching their lows, so we’re not fully convinced this particular rally is the end of the bear. Don’t get us wrong — we like seeing stocks rise, but the flimsy foundation of this latest move up makes us think stocks are more likely to hit a few more bumps than new highs any time soon.

 Going on Defense

One way to gauge market health is to watch performance trends for sectors underneath the market. When stocks rise, we like to see leadership from cyclical stocks, or sectors that benefit from higher economic growth (for example, consumer discretionary, technology, industrial sectors). That dynamic shows investors like the economic outlook enough to bet money on it.

The last bear-market bottom is a great example of this. The S&P 500 finally bottomed in March 2009 after dropping 57% over 17 months (with a few false-start rallies). In the following two months, the S&P 500 gained 38%, led by three cyclical sectors — financials, real estate and industrials. The U.S. economy entered a new expansion a few months later.

Lately, we’ve seen better returns from defensive stocks, companies that sell household goods, and necessities whose whose values tend to be less connected to the economic environment. These companies are generally considered the “safe havens” of the stock market, with greater stability and higher dividends. Three of the seven sectors outperforming the broader market since the March 23 low are defensive — utilities, health care, and energy. The notable move in energy shares has also been closely tied to oil prices.

This market makeup tells us that investors are still feeling relatively cautious, and they may be choosing defensive stocks for their dividend yields (amid lower rates elsewhere). Going forward, we’d like to see more interest in high-growth cyclical stocks like technology companies before we feel better about market durability.

Bad Breadth

We also watch market breadth, or a measure of how much support the broader market is getting from individual securities. Think of breadth as the foundation of a tower: You want a sturdy base at the bottom of the structure to ensure it doesn’t topple over. The same concept applies to the stock market — if a rally builds from a small pocket of stocks moving higher, the market is more susceptible to caving in.

Right now, investors are dealing with a case of bad breadth. About 70% of S&P 500 stocks are still in a bear market (defined as being 20% or more below their highs), and only 17% of them have climbed above their 50-day moving averages. In March 2009, about 64% of S&P 500 stocks were above their 50-day moving averages when the index first closed 20% off the lows. The market may be going up, but underneath the surface, individual stocks are still beaten down.

The Earnings Disconnect

Most importantly, we keep track of market fundamentals. After all, stocks tend to follow long-term trends in corporate earnings and economic growth.

We’ve talked a lot about how tough it is to gauge the economic impact, but it’s becoming clear that the coronavirus could be a significant event for corporate America. Earnings estimates for 2020 have dropped precipitously in recent weeks, and many companies have withdrawn guidance. Yet the S&P 500 is trading about 18 times above its projected earnings this year, a higher valuation than the benchmark’s long-term average price-earnings (P/E) ratio of 15.7x. For context, the average P/E ratio in past economic recessions has been 11.3x (according to CFRA).

First-quarter earnings season kicks off next week, so we should get more clarity soon.

Welcome volatility.

This latest move up has been a welcome form of market volatility. The world is moving fast, but there’s still a great deal of uncertainty present, even if investors try to focus on a better tomorrow. We believe the market may still need to take time to price in the obstacles ahead of us before this bear market truly ends.

The opinions expressed here are not meant to be used as investing advice. For more information, visit our website.
 

Lindsey Bell is Ally’s Chief Investment Strategist, responsible for shaping the company’s point of view on investing and the global markets. She is also President of Ally Invest Advisors, responsible for its robo advisory offerings. Lindsey has a broad background in finance, with experience on the buy-side and sell-side, in research and in investment banking and has held roles at JPMorgan, Deutsche Bank, Jefferies, and CFRA Research.

Lindsey holds a passion for teaching individuals how to become successful long-term investors. She frequently shares her knowledge as a guest on national news outlets such as CNBC, CNN, Fox Business News, and Bloomberg News. She also serves on the board of Better Investing, a non-profit organization focused on investment education.