Stock market rally broadens – though equities may be due for a small correction

ANTHONY SAGLIMBENE – CHIEF MARKET STRATEGIST, AMERIPRISE FINANCIAL

WEEKLY MARKET PERSPECTIVES — July 24, 2023

Market rally begins to broaden

With the stock market rally finally beginning to broaden to areas that didn’t perform as well as Big Tech in the first half of the year, the tone of the market has shifted materially, in our view. In July, Utilities are leading S&P 500 sectors higher as investors begin to discount the near end of Fed rate hikes while remaining somewhat defensively biased. Financials are also showing signs of renewed interest, as the big banks generally reported solid earnings results over the last week or so, and regionals show deposit trends stabilizing. Even Energy and Healthcare, two areas that struggled to gain traction in the first half, are showing signs of life again as investors look for value in areas that could see more opportunity if the rally gains steam in the second half. Bottom line: Investors should be encouraged that stocks, more broadly, are beginning to recover, and areas that have seen substantial gains in the first half aren’t falling out of bed.

Equities due for small correction

That said, near-term technical conditions across the stock market today are overbought, and in our view, equities are due for a small correction at some point. Bottom line: Near-term market conditions have become stretched, and a modest pullback of 5% to 10% could help cool some of the enthusiasm that has carried stocks higher as of late. Such corrections are normal and a healthy function of the market longer-term. However, we also believe such a pullback could eventually be met with more buying pressure, given primarily defensive positioning across investors, high cash levels, and building “fear of missing out” sentiment. The pain trade has clearly been higher over recent weeks, and some level of FOMO appears to be entering the market. Whether that can persist as the Q2 earnings season gains steam over the coming days and weeks remains an open question. Regardless, investors shouldn’t be too surprised if stocks take a needed breather at some point over the near term, even if investors who missed the rally over the last six months continue to look for opportunities to get more onside with their stock exposure.

From our point of view, light positioning across cyclical stocks outside of Tech, heavy short interest against the U.S. banks, near-peak Fed hawkishness, a resilient consumer, and still no meaningful capitulation from the bears could point to further upside for stocks. Yet, as we mentioned above, the stock market has come a long way fast. The Fed is likely moving rates higher this week, the number of stock market bulls has increased to levels not seen for over two years (a contrarian indicator), and thus far, Q2 earnings beat rates are running below the five-year average. 

Overall, sentiment is stretched, and we believe stock prices may be moving ahead of themselves modestly, assuming fundamental conditions weaken as we move through the rest of the year. As we have noted previously, it’s okay to be more optimistic about where the economy and markets currently stand at mid-year (plus a few weeks). And importantly, investors don’t necessarily have to wait for the next shoe to drop. But stock valuations are currently stretched versus history for the broader market. We’re also forecasting economic growth to slow in the second half and see only modest corporate profit growth through the rest of this year. Bottom line: As long as investors are reasonable about where stock prices can go through the rest of the year, we believe remaining cautiously optimistic about the market and economy at this point remains a prudent position to hold.

NASDAQ to impose special rebalance of the NASDAQ 100 

Following this year’s blistering rally across the Magnificent Seven, the NASDAQ 100 Index, which includes a heavy concentration of these stocks by market capitalization weight, has seen a year-to-date gain of over +41.0%. As a result of the substantial gains across a limited number of stocks, the exchange operator NASDAQ will impose a special rebalance of the NASDAQ 100 on Monday. To maintain compliance with the NASDAQ 100’s methodology and adhere to SEC rules around diversification and stock concentration, the Index will see a modest reduction in its exposure to its top holdings, which includes Microsoft, Apple, Nvidia, Amazon, Meta Platforms, Tesla, and Alphabet. The NASDAQ 100 has gone through a similar special rebalancing twice, once in 2011 and once in 1998. A special rebalancing in the NASDAQ 100 can occur at any time when the aggregate weight of the companies in the Index, each having more than 4.5% weight, tops 48% of the entire Index. Bottom line: With this year’s strong run across a handful of Tech and growth-related stocks, the NASDAQ is rebalancing the NASDAQ 100 to reduce concentration risk and comply with its methodology and compliance rules. And while some funds that track the Index directly will see holdings shift modestly, as smaller companies receive an increased percentage of assets from the larger holdings, overall market impacts from this rebalance should be small to negligible, in our view. The NASDAQ 100 rebalance makes for great headlines and not much else, as it’s just a byproduct of the incredible run across the Magnificent Seven this year. In this particular case, the “big get a little smaller.” But the giants of the NASDAQ 100 remain giants of the market and U.S. economy. Their influence on the overall market will remain remarkable — just slightly less so in the NASDAQ 100 compared to last week.

Speaking of the Magnificent Seven, Microsoft, Alphabet, and Meta Platforms all report second quarter earnings results this week and are included in the barrage of earnings releases this week, with over 160 S&P 500 companies on the docket. Thus far, 17.5% of S&P 500 second quarter results are complete. According to FactSet, 75% of S&P 500 companies have beaten earnings per share expectations, with earnings surprises coming in at just over +6.5% in aggregate. That’s lower than the five-year beat rate of 77% and the +8.4% aggregate surprise rate. Positive takeaways from early earnings releases include a resilient consumer, building disinflation trends, a benign credit backdrop, stabilizing deposit trends, and robust travel demand. Cautious takeaways from the earnings season include elevated macroeconomic uncertainty, a high bar for Big Tech, dampening pricing trends, profit margin risks, a challenging hiring environment, and a more selective consumer. Taken in total, the earnings season is progressing as we suspected, with company-by-company specifics and outlooks as the main driver behind market reactions.

All eyes on The Fed's policy decision

Lastly, all eyes this week will be on the Federal Reserve’s policy decision on Wednesday. The market widely expects the Fed to lift its target rate by another 25 basis points to 5.25% - 5.50% after pausing rate hikes in June. Notably, most of the market now sees a rate hike this week as the Fed’s last for this cycle. Expect investors to react to Wednesday’s policy statement and Fed Chair Powell’s press conference for insight on where rate policy goes from here. Also, this week will provide preliminary looks at July manufacturing and services activity (Monday), July Consumer Confidence (Tuesday), a first look at Q2 U.S. GDP (Thursday), home data across the week, and June PCE inflation (Friday). 

Outside the U.S., the European Central Bank (ECB) rate decision on Thursday will also be closely watched by investors. The ECB is widely expected to lift its target rate by another 25 basis points and keep its options open for a possible rate hike in September.