Stocks have seen a bumpier path in September, consistent with the typical seasonal weakness and our expectations. Entering October, choppy waters are likely to continue given the ongoing political wrangling and debt ceiling drama. That said, as we move later into the month, the seasonal backdrop should become more supportive. Moreover, we are encouraged by a sharp reset in investor expectations toward the economy, markets, and cyclical sectors, including small caps.
Markets are all about how data comes in relative to expectations as opposed to whether data is good or bad on an absolute basis. Our work suggests this reset to investor expectations is setting the market up for positive surprises later in the fourth quarter. Thus, we would stick with the market’s primary uptrend and use any weakness over the coming weeks to position for further strength into year end.
In today’s note, we highlight several charts we have been tracking recently as well as provide additional support for our outlook.
- Stocks remain in a historically-choppier period that tends to last into late October before a year-end rally. Since 1950, stocks have risen 79% of the time in the fourth quarter, with an average gain of 4%.
- Investor sentiment has been reset, which is a positive from a contrarian standpoint. The four-week average of bullish investors has dropped to just 30%, according to the American Association of Individual Investors (AAII). This is the lowest since last October, just prior to the election. Similarly, short-term newsletter writers are now recommending just an 11% equity allocation, down from 70% earlier this year, according to the Hulbert Sentiment Index.
- The Citi U.S. Economic Surprise Index is starting to turn up from depressed levels.
- Over the past three months, cyclical sectors have seen among the most dramatic fund outflows of the past 10 years, a dramatic shift from earlier this year when fund inflows were excessive. Our favored cyclical areas remain financials and energy, which should benefit from the better economic outlook we foresee and attractive valuations.
- After prices had moved too far too fast to the upside earlier in the year, over the past six months, small caps have witnessed one of the most extreme periods of underperformance of the past decade. Our view is that sentiment has now become overly negative and valuations very attractive, setting up a favorable risk/reward opportunity for small caps.
To read the publication in its entirety, please select "Download PDF," below.