Since early July, I have been cautioning about market weakness, and it has definitely arrived.
True, you don’t see it in the broad indices. The S&P 500 and Nasdaq are up 2.3% and 3.4% in the past three months.
While these indices are up moderately, anyone who is constructing broad portfolios of individual names is probably doing far worse. That’s because most of the market is in a correction. More than 70% of S&P 500 stocks are at least 10% below their recent highs, notes Jason Goepfert, a technical analyst at NextGen News.
“The S&P 500 has already crashed internally,” notes Larry McDonald of the Bear Traps Report. “Close to 60% of S&P 500 components are in a bear market, a 20% or more drawdown.”
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What’s the Problem?
Rising oil prices and the strong economy have investors worried about excessive inflation and the Fed rate hikes that might result. So, they are selling bonds. The yield on the ten-year bond is up sharply as a result. Historically, long-bond yields and stocks have an inverse relationship. Rates up, stocks down.
That’s what’s happening now. Interest rate-sensitive and long-duration areas of the stock market, like emerging biotech, have been especially hit. The State Street SPDR S&P Biotech exchange-traded fund (XBI) is down 7.6% since August 19. Emerging biotech stocks are long-duration stocks because most of their earnings will come in the distant future. Long-duration assets get hit harder in net present value models as the discount rate in those models (typically the ten-year bond yield) goes up.
What to Do Now
It’s a mixed picture. There is one very dark cloud developing on the horizon. Earnings estimate revision momentum is slowing down, notes Nick Raich of The Earnings Scout, which tracks earnings trends.
Typically, when stocks continue to rise and earnings estimate revisions slow for two quarters in a row, sustained market weakness ensues. We will have to wait and see how that develops. The jury is still out. Third-quarter results, which begin rolling out in earnest in the middle of October, will tell us a lot. “We remain positive on stocks, and technology stocks, through year end,” says Raich. “But if this trend continues, we could become much more defensive in 2027.”
Meanwhile, there are seven reasons to be bullish.
7 Reasons to Be Bullish Despite the Correction
- Since 1934, buying the S&P 500 at the end of September in a midterm year and holding into the next summer has produced positive results 100% of the time, notes Goepfert. That’s a pretty convincing record. He also notes that the S&P has most often rallied after more than 70% of S&P 500 stocks print at least 10% below their recent highs, which is the case right now.
The U.S. economy looks strong. “The U.S. economy remains remarkably resilient, which every recent data release seems to reaffirm,” says Ed Yardeni at Yardeni Research. Yardeni points out that the Atlanta Fed GDPNow model forecasts 5% third-quarter growth. Consumer spending is expected to increase 4.2%, the strongest since the first quarter of 2023. Business investment is on track for its strongest three-quarter stretch since 2021, he says. A big driver of that resilience is the AI buildout. The capex of the five largest U.S. hyperscalers will hit roughly $800 billion in 2026 and around $1 trillion in 2027. The federal deficit has increased, which acts as stimulus.
Another reason to be bullish on growth is that the U.S. economy is less interest rate sensitive than it used to be. Services now account for 61.3% of GDP. Services are generally less capital intensive. Baby Boomers, one of the big drivers in consumer spending, benefit from higher interest rates because this increases returns on cash. Baby Boomers have $97.4 trillion of net worth, and a lot of that is in cash.
- Pressure on U.S. and global leaders, and leaders in Iran, to resolve the conflict may get oil flowing again, fairly soon. Sustained oil prices above $90 and the related backup in bond yields put downward pressure on global economies. Likewise, Iran is feeling economic pressure due to the U.S. shipping blockade and increased banking and travel sanctions.
- Sentiment is not excessively bullish. The Investors Intelligence Bull/Bear ratio recently printed in the upper two range. It has to be above four to begin to signal caution on stocks in the contrarian sense.
- The September-October seasonally weak time of the year typically ends around October 12. The seasonally strong time of year then normally starts around the beginning of November.
- Investors are worried that Fed rate hikes might break something in the economy and cause a credit crisis. However, businesses and households currently have very strong balance sheets, which lowers the risk of this happening.
- Historically, bonds rally when control of one or both parts of Congress and the White House is in the hands of different parties, as is likely after the midterms. That’s because a divided government is less likely to carry out the kind of excessive spending that bothers bond vigilantes. The divided government effect could reverse selling pressure in the bond market, reducing bond yields.
The bottom line: A lot of stocks are in a correction at the moment, but you should look at this as more of a buying opportunity than a reason to be concerned.
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