The initial trading activity in the second quarter and April is leading investors to question whether the much-anticipated correction in the stock market is beginning. It's important to proceed with caution in drawing conclusions from just two trading sessions, particularly when considering the reduced market volume. However, several factors currently in motion may cause short-term concern for optimistic investors.
Rates
Interest rates have been a pivotal focus for the financial markets, with prevailing expectations that the Federal Reserve would lower rates three times in 2024. However, recent economic indicators, notably the latest Consumer Price Index and Producer Price Index readings, have dampened these anticipations.
The release of the Personal Consumption Expenditure (PCE) report, the Fed's preferred gauge of inflation, surprisingly didn't dampen the expectations of those anticipating higher rates. Federal Reserve Chair Jerome Powell's acknowledgment of the data, which aligned with expectations, initially received a positive market response.
This optimism was short-lived, as the March ISM Manufacturing survey revealed a shift above the 50 mark, indicating expansion for the first time since October 2022, with the Prices Paid component reaching its highest level since July 2022. This resurgence in commodity prices hints at renewed inflationary pressures in the goods sector, challenging the Fed's potential to reduce rates.
The likelihood of the Fed reducing rates in June, as indicated by the CME Fed Fund Futures, now stands at 59%. We would note the Fed has never acted on rates when this is below 60%. Moreover, the probability of three rate cuts in 2024 has fallen to 56%, with the chances of two cuts at 29%.
The timing of these rate adjustments is crucial, especially in a period characterized by limited news flow. The upcoming week promises an influx of economic data and commentary from Federal Reserve officials, with a significant emphasis on employment indicators. This mornings Job Opening and Labor Turnover Survey (JOLTs) numbers, aligned with forecasts, suggesting a persistently tight labor market.
Key forthcoming data includes the ADP employment report and ISM Services on Wednesday, Challenger Job Cuts, and Initial Jobless Claims on Thursday, culminating with the Bureau of Labor Statistics' employment report on Friday. Additionally, speeches from various Fed officials, including Chair Jerome Powell, throughout the week will further influence market dynamics, positioning economic data and interest rate responses as critical drivers for the markets at the beginning of April and the second quarter.
Seasonality
There has been a lot of talk about the possibility of investors selling stocks in order to cover their tax bills. This is plausible but taking a look at the seasonal patterns, this does not necessarily hold water.
April is a significant month in the stock market due to tax-related considerations. The April tax effect in the stock market refers to the trend where investors adjust their portfolios around the tax filing deadline in the United States (typically April 15th). This adjustment may involve selling stocks that have declined in value before the end of the tax year to realize losses, which can be used to offset capital gains and reduce the investors tax liability. This selling can lead to increased volatility and potentially lower stock prices in April as investors shed underperforming assets.
However, the seasonality trends of the stock market indicate that April has historically been one of the stronger months. Over a 20-year average, April has been one of the best months for major stock indices such as the NYSE Composite, S&P 500, and Nasdaq 100. For instance, the S&P 500 often sees positive performance in April, alongside other strong months like July and November, while it tends to struggle in June and September.
The phrase sell in May and go away captures the typical pattern where the period from November to May is usually positive, whereas June to September often sees flat or negative returns. This pattern holds true for the S&P 500 as well, with April being one of its best performing months based on data from 1980 to 2018, exhibiting an average gain of 1.52%. On the contrary, September has registered as the worst month, with average returns of -0.70%.
Historically, the first two weeks of April have shown positive returns in the stock market, with the S&P 500 displaying an average gain of 1.13% and a win rate of 65% from the close of March to Tax Day on April 15th. This period is typically one of the strongest in the year for the stock market. However, after Tax Day, the performance for the rest of April shows moderate gains, which are substantially less than the gains leading up to Tax Day.
In essence, while Tax Day and the weeks leading up to it have historically been associated with market gains, these patterns are based on historical data and are not predictive.
Light Volume Adds to Volatility
One area that bears are pointing to is the On Balance Volume. The On Balance Volume (OBV) serves as a measure to gauge the momentum of a security by accumulating its volume data. It operates by adding the trading volume on days the security's price increases and deducting volume on days the price falls.
The OBV stands out as one of the initial tools to quantitatively assess volume inflows and outflows within the market. Analysts utilize OBV to identify discrepancies between it and the price movement, which could indicate impending shifts in price. Alternatively, OBV can reinforce the validity of current price movements.
This measure has shown some divergence from the recent run up. What this reflects is that some of the recent gains in equities have come on light volume. This means that the current correction we are seeing has more to do with the ease of recent light volume gains then any meaningful selling.
We saw some of the lightest trading volume days in the week ahead of Easter which is typical for a holiday period. It has not taken a lot of effort to erase the recent gains.
Earnings Reactions
Bears are likely to cite earnings as another catalyst for investor sell-off. Despite a lull in the quantity of earnings announcements in recent weeks, the movements have been significant. Companies like Nike (NKE), LuluLemon (LULU), and PVH Corp (PVH) have all experienced double-digit percentage losses, largely attributed to the forward-looking statements these companies have issued. This is particularly concerning given their prominence in the consumer sector, which accounts for 66% of the U.S. economy, highlighting that any sign of weakness cannot be overlooked.
This raises concerns about a possible misstep in Federal Reserve policy, with recent inflation data potentially being misleading. A downturn in employment figures would further illuminate the consumer's financial health.
The upcoming Q1 earnings season, kicking off with major reports from J.P. Morgan (JPM), Wells Fargo (WFC), and Citigroup (C) on April 12, is highly anticipated. This date marks a critical moment for gauging the broader economic landscape, especially consumer health, as market participants will be keenly observing credit trends and their correlation with rising interest rates.
In essence, earnings outcomes and, more importantly, company guidance are currently acting as a drag on market sentiment. Nevertheless, a broader range of corporate results expected in the near future will provide more clarity. In the meantime, the scarcity of information is contributing to some preliminary selling pressure.
Investors are advised to pay attention to the pre-announcement season, where companies offer preliminary insights into their performance. Often, this period includes cautionary statements from companies anticipating results that fall short of analyst expectations. A lack of concerning news during this time could signal positive momentum for the Q1 earnings season. This would ease some valuation concerns.
The Bottom Line
Numerous factors suggest why there's been a downturn in the early part of Q2. Yet, it's essential to note that the long-term upward trajectory on the charts remains intact. The shifting interest rates are crucial to monitor, as they may mark a pivotal moment for the wider market. Nevertheless, the cause of rising rates—robust economic indicators fueling persistent inflation—does not automatically signal a need to sell. Historically, markets have managed well with the 10-year yield surpassing 4%. Indeed, the recent surge in sentiment, such as the AAII data hitting over 50 last Thursday, indicates a market that may be overbought. This is corroborated by the 14-day RSI for the SPY, which has decreased from the high 70s to 56 following two days of selling.
For the coming fortnight, market participants would do well to prepare a list of potential investments to acquire during a market dip. The Fear Of Missing Out (FOMO) dynamic remains robust, with no signs of disruption. What we're observing is the market shedding some of its lighter, frothier aspects. While bears may declare the onset of a correction, a strategy favoring dip-buying with an expectation for the bull market to persist until the end of May seems judicious.
At that point, we'll have the opportunity to reevaluate, especially as the Sell in May and go away idiom starts to permeate headlines. A deceleration in earnings growth could be a factor that brings this adage to life. However, maintaining a bullish stance is advisable for now, albeit taking a cautious pause over the next two weeks could be wise, considering the current frothy market conditions on low volume.