- The S&P 500 is hovering near record highs, but there are signs of underlying weakness.
- Market breadth, as measured by the percentage of stocks above their 50-day moving averages, is down.
- Strategy Ed Clissold shared what he's watching and where he's investing before the US elections.
US stocks may not be as strong as they look, a long-time strategy chief warns.
From afar, the market seems to be on solid ground. The S&P 500 roared to record highs in May on the back of upbeat first-quarter earnings reports and an encouraging inflation reading that, in a slowing economy, could convince the Federal Reserve to cut interest rates later this year.
Those tailwinds, plus positive investor sentiment and a solid long-term technical setup, have kept Ed Clissold, the chief US strategist at Ned Davis Research, bullish about equities.
However, Clissold cautioned in a recent interview that cracks may be forming under the market's surface, seconding concerns he raised in a late-May note that stocks could top out soon.
Market breadth has worsened materially since the start of the year, the veteran strategist noted, meaning the S&P 500 is increasingly propped up by a smaller number of high-flying stocks.
Less than 45% of companies in Ned Davis Research's multi-cap universe were trading above their 50-day moving averages in late May — down from a tick over 90% in late December and 79% in late March. This popular technical indicator means most stocks were trading below their typical levels from the last few months, even if they were faring rather well on a 200-day moving average basis.
While weakening breadth and a wider gap between shorter- and longer-term momentum isn't a sign of a market crash, Clissold said it should be a legitimate concern after stocks' massive rally.
"The fly in the ointment is that there were some small technical divergences that popped up in May," Clissold said. "We view it as our job with our clients to highlight those and make sure that's on people's radars."
Brace for a softer second half
Fittingly, the S&P 500's surge to historic highs has defied historical precedent.
Stocks typically struggle in the first half of US presidential election years and bottom out in May, Clissold said. Choppiness tends to persist until there's clarity about who won the White House and Congress, at which point there's often a sizable year-end rally.
Although the outcome of this November's election is far from certain, the major candidates have long been crystallized. Barring a shock, incumbent Joe Biden will face former President Donald Trump, the first showdown between current and former presidents since 1892.
"This is unprecedented in modern financial history," Clissold said. "The stock market has not had to wrestle with the uncertainty over who the nominees are going to be. And so that's probably part of the reason why the market's been able to shrug off some of the political uncertainty."
Clissold suspects the election-year script could be flipped in 2024. Instead of a shaky first half and strong second half, he's bracing for a pullback heading into the election. The market may also react poorly if there's civil unrest or significant changes to the status quo after the election.
Other potential risks include reaccelerating inflation, which would cause the Fed to postpone rate cuts; and disappointing earnings, which would put pressure on stock valuations.
"Management teams guide lower and then they exceed the lower numbers, but there does seem to be some vulnerability to the second-half numbers," Clissold said.
How to invest with the election on the horizon
Despite Clissold's concerns, including those about fading market breadth and momentum, he isn't moving off his overweight recommendation for US stocks since he still sees opportunities.
Two sectors look especially attractive in the near term, Clissold said: financials and utilities. Both would benefit from rate cuts, as financial firms would be more profitable if short-term rates fell and the yield curve steepened while utilities' yields would become more appealing relative to bonds. Utilities also have under-the-radar exposure to artificial intelligence, Clissold noted.
AI stocks continue to dominate, and Clissold is confident that the trend can continue for years, especially as the labor force contracts once baby boomers retire. He's also encouraged that top AI companies like Nvidia are highly profitable, unlike the leading firms during the dot-com boom.
Still, Clissold wouldn't advise investors who are light on growth stocks to dive in headfirst now.
"We are not telling our clients to jump into growth stocks at this point," Clissold said. "You want to wait and see if you get the breakout or if value does have another multi-month renaissance."
Clissold continued: "Eventually, probably, the growth story will go up because of what we talked about — the fundamentals are so positive. But we're at a critical technical juncture for growth versus value where it makes sense to be prudent."
Additionally, Clissold is steering clear of stocks in the consumer staples and real estate sectors.
Consumers — especially those in the lower-income cohort — are getting pinched by elevated interest rates and inflation, the strategy chief noted, adding that credit-card balances have soared since excess savings have evaporated. That's a serious headwind for companies in the consumer staples sector, which also tends to underperform during bull markets.
Real estate is the only sector that's lost ground this year, as many office buildings are in sad shape after the pandemic. But Clissold said the group could rebound once interest rates fall.