Bull markets often correct through sector rotation. We might be in the midst of one. Mege-caps, which is the best-performing group year-today, is down almost 2% today while smaller caps are busing higher across the board:
Bull markets climb a wall of worry. The most recent threat is the resumption of interest rate increases. The 10-year yield is back above 4% and extremely close to making new year-to-date highs. Rising rates mean rising inflation expectations. If yields continue to perk up, the whole rally might crumble under their weight.
Ever since stocks topped in October of 2021, the Nasdaq 100 (QQQ) has been highly correlated to Treasuries. When interest rates went up, QQQ went down and vice versa. This relationship continues up until April of this year when all of a sudden we saw a big divergence. Rates remained relatively subdued while QQQ skyrocketed. Now that rates are rising steadily again, QQQ is starting to feel some pressure. Rates are the single biggest factors that can define the destiny of stock prices in the long-term and they might foreshadow further yield increases by the Fed.
The other major force that has a significant impact on stocks is earnings. The next earnings season starts on Friday with a few banks reporting. Most stocks have gone up substantially higher between last and this quarter. This usually means that high expectations have been priced in and they will be hard to exceed. As always, what truly matters during earnings is the market reaction to them. In the past couple of quarters, we saw plenty of companies that missed earnings estimates and reported negative growth. It didn’t matter. Their stocks still went up. In fact, this was the single biggest and the most forward-looking factor that predicted that inflation will gradually fall. Now, it remains to see how the market will react to earnings this quarter. If we see most companies that beat estimates and then gap up and follow through higher, this bull market is likely to continue. If all of a sudden stocks start selling off despite beating earnings estimates, the correction might be just around the corner.
There’s currently no evidence that this bull market is over. It’s true that breakouts had issues following through last week and we saw a lot of fading. It’s also true that the dips in strong stocks continue to lead to great buying opportunities. We are currently in the consolidation phase as a big run. I call it range-bound trading. In this environment, one has to be very nimble when trading breakouts and take profits quickly and often. Focusing on a pullback to 20 or 50-day moving averages is likely to offer a lot better risk -to-reward especially for swing trades.
Inflation continues to come down. Stocks keep going up. The Nasdaq 100 just had one of its best quarters in history. A.I. and falling inflation have truly changed the market sentiment and the way companies spend. I don’t know if the current move has fundamental merits or if it is rational. I don’t know how long it is going to last. No one knows. Two things make sense in this tape:
Don’t fight uptrends. More money has been lost anticipating corrections than during the corrections themselves.
Don’t chase extended stocks. Find a low-risk entry point to participate. How to find one. Every time a rising stock has a pullback to its 10, 20, or 50-day moving average, it offers a low-risk opportunity where we can risk $1 to make $3-10. We don’t know in advance which ones are going to work but this is not the important part. What matters is quickly closing the positions that hit our stops, holding the ones that work, and even adding to the winners. It’s a very simple concept but it takes time and deliberate effort to train our mind to behave in a way that makes us money in financial markets. Setups and indicators have never been the solution in trading. You can have the best setups and the most sophisticated indicators and analysis and still underperform the S&P 500.
So what can stop this bull market? This is probably not the right question to ask. There is always something to worry about. If there aren’t, there wouldn’t be any buyers left. The Fed might decide that inflation is not coming down fast enough or it might perk up again and keep raising rates. Corporate earnings might not reflect the cheerful projections that the market has priced in. There are always many reasons but knowing about them is not going to make you money. There will matter when they matter and we will see it in the price action. No reason to guess when. The biggest risk for a money manager during a bull market is not participating in it properly – being underinvested or underperforming. This is why the dips in strong stocks tend to get bought.
Bull markets often correct through sector rotation. There was a glimpse of it last week. On the day tech stocks were under pressure, financials and energy stocks stepped up. Those rotations are bullish because they reveal that capital is not leaving the market but merely moving into better opportunities.
