What happened to the “summer doldrums?”

The long-running cliché about “summer doldrums”—when the stock market is typically sluggish as institutional and individual investors take time out to relax on vacations—has been stood on its head. The U.S. market has been anything but dull lately.

After the S&P 500 reached a low point on June 16, closing down 23.1 percent year to date, the market rallied notably, regaining much of that lost ground. The S&P 500 ended Wednesday’s session down “only” 10.3 percent.

S&P 500 has rebounded off its mid-June low (YTD % change)

Line chart showing the daily percentage change in the S&P 500 Index from January 1, 2022 through July 25, 2022, relative to its level on December 31, 2021. The Index’s all-time high on January 3 was followed by a decline through the end of January due to inflation and concerns about Federal Reserve interest rate hikes. On February 11, the market started factoring in Russia-Ukraine risks, and fell 5.6% between that date and its low point on March 8. In total, the market declined 13.1% by March 8 on a year-to-date basis. The market subsequently rebounded and surpassed its February 11 level by March 18, recouping the losses from the military intervention. From April through mid-June the market recorded its biggest pullback so far this year, reaching a low point on June 16, down 23.1% year to date. Since then it has bounced, regaining some of that lost ground. As of August 17, the S&P was down 10.3% year to date.

1. Jan. 3: All-time high
2. Inflation, Fed rate hike concerns
3. Russia & Ukraine risks
4. Rate hike, economic, and earnings concerns
5. June 16: -23.1% year to date
6. Stocks rallied on tamer inflation data, less Fed fears, good Q2 earnings reports
7. Aug 17: -10.3% year to date

Source – RBC Wealth Management, Bloomberg; daily data through 8/17/22

Developments that lifted the market …

• Tamer inflation and prospects for a further retreat. Yes, there is definitely much more to do on the inflation front and it could take a while, but with headline consumer inflation easing to 8.5 percent in July from 9.1 percent in June, the data are finally moving in the right direction. Declines in oil and gasoline prices and other commodities thus far in August should help the process along.
• A vigilant and “data dependent” Fed. Officials have stated they are determined to do whatever it takes to combat inflation. They also have emphasized they will be sensitive to incoming economic data and will adjust monetary policy accordingly. The combination of inflation vigilance and flexibility has diminished market participants’ concerns that the Fed could overreach by raising rates much higher than is warranted.
• Q2 earnings not just “better than feared,” but better than expected. S&P 500 revenue and profit results have been good overall. Many companies are coping with inflation and economic imbalances. With over 90 percent of S&P 500 companies having reported, earnings growth is pacing at 9.7 percent year over year. This is markedly higher than Wall Street analysts’ 5.5 percent consensus forecast at the start of earnings season.
• Not all economic indicators are rapidly decelerating. Q2 GDP was decidedly negative for the second-straight quarter and some data since then have come in rather weak (New York region manufacturing, housing starts, and small business optimism), but the economy is not down for the count. The all-important and outsized services sector is still expanding at a healthy clip, national retail sales have been relatively resilient, and employment remains firm.

As these positive developments were absorbed, a reversal took place within the stock market.

The indexes and sectors that had been among the weakest through the first half of the year have rallied the most since the market reached a low point in mid-June. Small-cap stocks (Russell 2000), and the Consumer Discretionary and Technology sectors within the S&P 500 have been particularly strong.

Performance since the low on June 16, 2022

Bar chart comparing returns for four major U.S. indexes and S&P 500 sectors from the low on June 16, 2022 through August 17, 2022. Returns for the indexes are as follows: Nasdaq, 21.5%; Russell 2000, 20.5%; S&P 500, 16.6%; Dow Jones Industrial Average, 13.5%. For S&P 500 sectors, the returns are: Consumer Discretionary, 27.9%; Information Technology, 21.9%; Utilities, 18.8%; REITs, 17.6%; S&P 500, 16.6%; Industrials, 16.6%; Financials, 15.8%; Consumer Staples, 11.9%; Health Care, 11.3%; Telecommunications Services, 10.8%; Materials, 7.7%; Energy, 0.0%.

* The Russell 2000 is a small-capitalization stock index

Source – RBC Wealth Management, Bloomberg; data through 8/17/22

Conversely, the Energy sector has been the worst performer since the June low, as crude oil prices have retreated significantly. This sector had been the strongest—by far—previously.

On a year-to-date basis, the Energy sector is still leading by a mile (+39.3 percent), while Communication Services is lagging the most (-25.0 percent).

Market reinforcements in waiting?

We think there are reasons the market could find support in the near term.

There have been numerous stock buyback announcements during the Q2 earnings season, which come on top of other companies’ previously announced plans.

According to reports from our research providers, some institutional investors are experiencing FOMO—the “fear of missing out” on the rally—so they could increase exposure in coming weeks.

Some technical indicators are flashing positive signals. In the post-WWII era, when the S&P 500 recovered 50 percent of its bear market losses (like it has recently), the market did not subsequently trade down to a new lower low during the cycle, according to CFRA Research.

Based on data going back to the early 1900s, a study by research provider Fundstrat found that after the 50 percent retracement threshold was reached, the market went on to rally further 12 months later on 86 percent of occasions, with an average gain of 13 percent.

Stay vigilant

These positive signals are encouraging, but now is not the time to become complacent, in our view.

The inflation battle has not yet been won. Assuming consumer prices retreat further this year and next—as RBC economists anticipate—it’s not yet clear by how much they will decline. We doubt wage inflation has fully run its course, and inflationary pressures in certain segments of the economy could remain sticky. We think price trends in the non-commodity components of the Consumer Price Index will be key to the inflation story.

Economic data seem vulnerable to further slowing and a formal, broad-based recession is not out of the question. When the Fed hikes interest rates, there is usually a lag of some months before higher borrowing costs begin to weigh on economic activity. The most important leading indicator in our recession scorecard deteriorated recently.

S&P 500 estimates for 2023 declined moderately during the Q2 reporting season. They could decline further as the impact of previous and forthcoming Fed rate hikes kick in—the question is, by how much?

We think the bulk of the equity selloff and market risks are likely in the rearview mirror—as long as the Fed refrains from slamming on the brakes too hard, and inflation doesn’t sit at rather elevated levels for a prolonged period.

We continue to recommend holding Market Weight (neutral) exposure to U.S. equities. This is designed to balance lingering recession risks with the possibility that ebbing inflationary pressures and slowing growth could provoke a change of heart by the Fed as early as the first half of next year.