What we’re watching to help us gauge if / when the pullback has run its course
On Thursday the S&P 500 ended the day 5.1% below its late-October high, officially entered into what we consider to be a tier 1 / garden-variety pullback on our tiers of fear framework, something we think has been long overdue for a number of reasons despite our constructive view on the year ahead. The list of things we’re watching to gauge if and when the pullback is done is too long to dig into in this podcast. A few that are top of mind:
To start with, valuations, which have only improved a little for the workhorses of the stock market. FY2 P/Es for the S&P 500, the top 10 market cap names in the S&P 500, and the Nasdaq 100 have been unable to expand since the late summer, essentially bumping up against the peaks or ceilings established pre and post COVID. As we look across these valuation indicators today, we see slight but not substantial improvement. There’s no magic number valuations need to go to before markets can find their footing again, and it’s possible they will simply remain stuck around current levels until a new year of earnings forecasts cycle in. But if the pullback persists, these charts will be helpful in identifying the moment in which bargain hunters get tempted back.
There’s been more progress on valuations made in Small Caps, where the Russell 2000 market cap weighted FY2 P/E has fallen from the 16.5-16.9x area that it’s been hovering around recently to 15.8x in our latest update. Moves to average often end up being an important line that is not crossed.
“Bitcoin needs to start behaving better. The choppy trends in bitcoin since the summer have been something we’ve interpreted as a sign of fatigue among retail investors.”
Lori Calvasina, Head of U.S. Equity Strategy, RBC Capital Markets
We and other stock market watchers have highlighted how bitcoin has been positively correlated with the S&P 500 and other major indices in recent years. While it’s not clear to us exactly what’s causing bitcoin to drop, stabilization in this corner of financial markets would likely help to calm some nerves within US equities as well.
Separately, bulls have already pulled back a lot on the AAII survey. We’ve included the recent deterioration in net bullishness on the weekly AAII survey (American Association of Individual Investors) on our list of things worrying us about the stock market in the near term mostly because it’s unusual to see net bulls fall without a noteworthy dip in the stock market. I’s important to take note of how far sentiment has already fallen on this gauge.
Net bulls have already fallen back down to levels that marked the low in August/September, and the four-week average is at a level that tends to be followed by a 10.8% forward return in the S&P 500 over the next 12 months. That being said, this indicator is not yet back down to the more extreme lows of 2022 and early 2025. This indicator captures how we feel about the pullback generally. It’s possible the decline in net bulls has more room to go, but for longer-term US equity investors, it’s already on the list of intriguing data points.
And finally, stocks have been Fed up. In recent years the S&P 500 often rises when Fed-cut expectations are dialed up, and tend to come under pressure when Fed-cut expectations are dialed down or hikes gets baked in. After Friday’s strong rebound, it wasn’t surprising to us to see that Fed-cut expectations had improved slightly.
We’ll wrap up this topic with a little bit of historical context. When recession fears or systemic issues are kept off the table, pullbacks tend to be limited to the 5-10% range. A 10% move off the late-October high would take the index down to roughly 6,200, but there have been several periods of stress that felt rather intense in the post-COVID era that haven’t seen stocks hit that threshold, such as the Japanese carry trade unwind of August 2024 and late 2024/early 2025 profit taking.
What’s working, or starting to work
At the index level, Value has been beating Growth which persisted on Friday. Small hasn’t been beating Large but did so on Friday. Unlike what we saw in early October, the Russell 2000’s leadership was not driven by the outperformance of the quantum names that had become big weights in the index, a sign that it may be more real.
“Health Care is the only one of the three that has been seeing positive EPS and revenue revisions trends in recent months”
Lori Calvasina, Head of U.S. Equity Strategy, RBC Capital Markets
Sector wise, within the S&P 500, Health Care, Consumer Staples, and Energy have been the top performing sectors since late October when Tech performance peaked relative to the S&P 500. These three sectors appear to have some of the most attractive valuation profiles in the S&P 500, but Health Care is the only one of the three that has been seeing positive EPS and revenue revisions trends in recent months – one of the reasons why we’ve been highlighting it as our preferred defensive in a broader market drawdown and Energy and Health Care have both been seeing strong inflows.
Finally, the market has been flipping to safer factors. Within both the Russell 2000 and S&P 500, high earnings quality, low vol, low price momentum, and high dividend yield are all starting to outperform, a sharp reversal in leadership.
