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Are stocks set for a summer swoon?

Stocks have been in rally mode over the last 15 weeks, with market indices trading at their highest levels in a year. But as the quarter draws to close, strategists say stocks are due for a correction. — By Roland Jones
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The market has been in rally mode over the last 15 weeks, its main stock indices rising to their highest levels in a year. The blistering advance has spurred renewed interest in equities, most notably from individual investors, but as the second quarter draws to close, some market savants say stocks are poised for a modest correction.

The thinking among many strategists is the market’s stellar performance in the second quarter, which was led by more volatile small-cap stocks in the biotechnology and technology sectors, may come under some selling pressure in early July, as the third quarter gets underway and money managers discard the prior quarter’s best-performing stocks, their respectable quarterly portfolio performances already in the books.

Some market strategists also expect to see a sector rotation in the market, as investors shift funds from volatile technology and biotechnology stocks and buy up steadier, large-capitalization issues.

The market’s strong rise over the last three months has been striking, with the Standard & Poor’s 500-stock index, a broad market measure, up over 23 percent from its closing low for the year, hit on March 11. The Nasdaq Composite index, which tracks stocks in the technology sector, has gained over 27 percent over the same period. And the American Stock Exchange’s biotech index, which also bottomed in mid-March, is now up over 38 percent.

“It has been a good quarter,” David Briggs, head of equity trading at Federated Investors, told CNBC last week. “But there is some concern that there’s some pent-up selling pressure in the market, and that traders are postponing it until July.”

Richard Cripps, chief equity markets strategist at Legg Mason, agrees. Most portfolio managers have already beaten the performance of the S&P 500 index for the year, he said, and are looking to lock in their returns. “They’re looking to invest in safer blue-chip stocks to ride out the rest of the year,” Cripps added.

Rally has upside potential
Cripps sees the S&P 500 index falling to as low as 900 in the near term, but thinks the market’s rally has more upside potential, with the index reaching 1,100 by year end. While higher-risk stocks have provided the biggest gains in the market’s “initial” rally since mid-March, the next stage of the market’s advance is likely to be more “discriminating,” he said.

Cripps sees a short-term correction in stock prices of about 5 to 10 percent from the market’s recent high. “Then I think we’ll reload and push higher,” he added, the next advance led by companies with quality fundamentals, higher dividend yields and lower volatility. “These features favor large, blue-chip stocks” that have lagged in the recent rally, he said.

In a recent study, Cripps singled out 13 stocks in the S&P 500 index that are likely to benefit from the next phase of the market’s rise, including names such as Merck, Kimberly Clark, BellSouth, American International Group and Home Depot.

The group’s dividend payout ratio (the percentage of a company’s earnings that is paid to shareholders in dividends) is about 35 percent, which is low, but leaves room for growth, according to Cripps. Over the last five years the average annual dividend growth for the group has been 11 percent, much higher than the overall S&P 500 index, which grew 4.5 percent, he added.

“Biotechs and small-cap techs have put on a tremendous performance [this quarter]; we were at the bottom of a cyclical bear market in mid-March, so they benefited from a sharp change in market sentiment,” Cripps continued. “But the next stage of the rally will be related to fundamental improvement, so it will be driven by large-cap companies that have better fundamentals and a lot less risk.”

Lackluster summer volume
As Wall Street enters the traditionally lackluster summer season, when trading volumes drop off and activity on Wall Street lessens, Peter Cardillo, chief strategist at Global Partners Securities, also expects to see a correction in stock prices. “I think we’ll see a pull-back of some 3 to 5 percent — anything more could give the bears the upper hand.”

“I’ve noticed the market has tended to go up on heavy volume, so we might see a slow drift downwards rather than a sharp sell-off,” Cardillo said. “But traditions don’t always hold true; last summer the market was very volatile,” he added.

The beginnings of a pull-back could come as soon as Wednesday, according to Chip Hanlon, chief domestic strategist at Euro Pacific Capital.

The U.S. Federal Reserve is widely expected to reduce interest rates for the thirteenth time in at the conclusion of its two-day policy meeting Wednesday, and the market has already priced in another rate reduction, although it is uncertain as to whether the reduction will be a quarter-percentage point or a half-percentage point.

There may be some palpable disappointment in the market, as Wall Street realizes that another rate reduction, whatever the size, will not be a panacea for equities, said Hanlon.

“The market has been rallying in anticipation of this rate cut, as Wall Street realizes that the Fed has no more ammunition left,” Hanlon said. “The first 12 rate cuts haven’t helped yet, so I don’t see why number 13 will be the magic bullet this market needs.”