After its recent bounce, the S&P 500 is now wrestling with our near-term upside target in the 2,700 range. In my view, we are starting to see evidence that the market is normalizing, setting the stage for a bottoming process to begin. And even if the market sees new lows in that process, I believe it will hold above 2,000 – 2,100. From this point forward, however, I think whether or not we retest the bottom before moving higher is irrelevant. I believe it is time to ignore the market and instead focus on the factors, regions, industries, and stocks that will lead in the next bull cycle.
Will the market see new lows?
The dominant consensus view seems to be that the market will see lower lows. Investors then appear to be split between the bulls and the bears, but both camps seem to confidently expect this near-term outcome. My best-case scenario is more bullish, with the S&P continuing higher without a retest of the bottom. Though this would break with longer-term historical precedent, it would mirror what happened in 2019 after the lows of Q4 2018. Until recently, my outlook assigned a 35% probability to this scenario, whereas the combination of the consensus new lows followed by a recovery to a bull market had a 65% probability. However, a strong close above 2,700 could indicate that the best-case scenario is playing out. In fact, at this point, I am actually leaning toward no new lows, particularly since so many investors (bull and bear alike) expect them. Importantly, however, I believe it really doesn’t matter.
Either way, the waterfall decline should be over
Regardless of whether or not we get new lows, the market should now begin to differentiate between the winners and losers of the next cycle. This impending differentiation is what drives the “divergences” that characterize a bottoming process. Specifically, divergences develop as the index moves to new lows, but most stocks do not follow. At the same time, sentiment does not get as bearish, and correlations and volatility do not get as high (i.e., the macro-driven waterfall is over).
This list of inputs is generally referred to as market internals. If we are indeed in the beginning phases of a bear-market bottom, as I believe we are, we should not see market internals go to new lows, even if the index itself does. This would mean we need to shift our emphasis away from macro-technical conditions (the market) toward micro-technical conditions (stocks). In other words, as the waterfall decline ends, the market is no longer all that matters.
It’s time to focus on tomorrow’s leaders
We should therefore focus on recognizing the factors, regions, industries, and stocks that the market is selecting for future leadership. Of course, the market constantly differentiates between winners and losers, even during waterfall declines. Importantly, divergences would make this differentiation more pronounced. Until recently, winners have been safety, growth, momentum, the US, China, and stocks that benefit from COVID-19. Losers have been cyclicals, value, Europe, and stocks that are in harm’s way of COVID-19. From here, as we transition regimes from waterfall back to bull cycle, some mixture of new leadership should begin to emerge, whether we retest the bottom or not.
Though the market could fall to new lows with no divergences to speak of, this scenario is not in the cards for me. In my view, even if it does move lower, the S&P 500 will hold near our previous bottom and there will be clear differentiation between winners and losers. If that is the case, I believe investors should start looking for leaders now.