Stocks could go higher, but they may take a breather first, strategists say

Stocks have jumped nearly 7% in just five weeks and may be ready to take a short breather, but strategists say a powerful rotation is at work and that could propel the market much higher.

Strategists see more upside because investors had gotten too pessimistic earlier this year and loaded up on what they viewed as safer bets. These defensive stocks had been in favor, but they have been selling off while more cyclical names have been rising.

The shift also correlates with better fundamental news and improved sentiment about trade talks between the U.S. and China.

“If you look at the flows of the SPDR ETFs, year-to-date, utilities and staples have each taken in $1.5 billion, while the industrials have seen $1.3 billion in outflows and financials had $2.4 billion in outflows,” said Todd Sohn, technical strategist at Strategas Research. “Those spreads were much wider a few months ago.”

The S&P 500 has practically gone straight up from its Oct. 8 close of 2,892 and has surged to as high as 3,102 this week. The S&P was trading lower on Thursday.

Sohn said the defensive sectors are still over owned. The S&P utilities sector lost 1.4% in the past month, while financials are up 6.5% and industrials are up 5%.

“You could get a 3 percent pullback, just a little reset, then we could go higher,” said Sohn. “Overbought conditions in an uptrend are very bullish, and it’s being accompanied by cyclicals and risk-seeking leadership.”

JP Morgan technical strategist Jason Hunter sees the same trend, and he says it’s possible that financials will take on the market leadership as stocks go higher.

“We believe a continued unwind of crowded defensive positioning that reached its zenith in August can carry the rally through the fourth quarter,” Hunter wrote in a note. “For the S&P 500 Index, the near-term bullish bias stays firmly in gear while above the 3,020-3,025 breakout area, with medium-term support at the 2,938 breakaway gap.”

Hunter said the next notable chart level for the S&P 500 is 3,225.

Bank of America Merrill Lynch strategists have an even higher possible target for the S&P 500 — 3,850.

They see the market as having the potential to gain another 20 plus percent. In a note earlier this week, the strategists said the rally has been broadening and other indexes, beyond the S&P, are breaking out. They say the market is behaving much as it did in the last two periods of consolidation, and the breakout move could take the S&P 500 to 3,850 if the move is in line with historic patterns.

“History suggests that breakouts from these ranges should be powerful,” the BofA strategists wrote in a note. On the S&P 500, the 3,063 level was the “bears’ last stand.”

SentimenTrader pointed out that when investors move out of low volatility stocks but the S&P 500 gains, it could be a set up for a sell off. On Twitter, it noted that a decline in the S&P 500 Low Volatility Index and a rally of more than 5% in the S&P typically precedes a period where stocks fall over the next two weeks.

The small cap Russell 2000 index has so far failed to regain its 2018 highs and strategists say it would be a positive reinforcement of the uptrend if the Russell could break out of its current range.

Hunter said the Russell has gotten stuck in the resistance range of 1,590 to 1,620. The Russell was barely higher, just under 1,590 Thursday.

“Bigger picture, a break above the 1,600-1,618 2019 range highs would open the door for an advance to next resistance at the 1,640 Sep 2018 78.6% retrace and then the 1,678 Dec ’18-Jun ’19 .618 swing objective and 1,702-1,705 Oct 2018 highs,” Hunter noted.

Sohn said it would be good for sentiment if the Russell joined the move and at least get back to the highs of the year.

“The Russell is on the goal line. You’ve been sideways since late February. It would be another piece of evidence equity participation is broadening,” said Sohn. :What’s helpful is the largest group in small cap is is banks and they’re starting to improve.”

Hunter said financials could become the market leaders and notes they have correlated to global manufacturing data throughout the current business cycle. Economists are seeing a pickup in the Purchasing Managers’ Index, and some expect a reversal of the contraction in U.S. ISM manufacturing data.

“If the leading markets accurately forecast a PMI rebound into 2020, Financials have the potential to take a leadership role, providing a potential tailwind for the Value index as Financials make up the largest sector weighting,” noted Hunter.

Sohn said the market could rest before moving higher, but it has more positives going for it than at the same time last year.

“I think bigger picture is the market is almost coming out of a two-year range here. A bear market in some cases,” he said.

“I want to keep that in mind heading into 2020. A big difference is what’s going on globally. A lot of global markets peaked in January 2018, and they were down most of last year. It was a bear market for global equities. Now in the fourth quarter of this year, they’re actually participating in the move. The U.S. may still be the lead performer, but it’s more participation, more confidence in the equity backdrop. That’s a notable difference.’