Insights + Resources

Market Update – What a Pullback Could Look Like

Aug 16, 2023

Key Takeaways:

• While there is strong support for stocks being in a bull market, overbought conditions, weak seasonality, rising interest rate volatility, and ongoing uncertainty over monetary policy suggest a shorter-term pullback in this rally could be underway.
• In terms of downside, support for the S&P 500 sets up at 4,450 (June highs), 4,432 (50-day moving average), and near the 4,200-4,300 range (uptrend/prior highs). We believe the latter support range is the most likely spot for a bounce given the confluence of support in this area, the degree of record-high cash sitting in money market assets, and the fact many investors missed the first half rally.
• Don’t panic—pullbacks are normal, even during years with above-average returns. History suggests a 5-10% drawdown between now and year-end is not uncommon, even during years with strong rallies into August. However, even with a drawdown, the S&P 500 has still historically generated positive average returns into year-end.

Stocks have pulled back modestly this month as overbought conditions met overhead resistance. Interest rate volatility spurred by Fitch’s downgrade of the U.S. credit rating, monetary policy uncertainty, stretched valuations, and underwhelming economic data in China have also weighed on risk appetite. The S&P 500 is down 2.6% month to date (as of August 10) after struggling to surpass the 4,600 area. While this is hardly a drawdown by most standards, it is enough to raise the question of where potential support sets up if the selling pressure continues.

As shown below, the S&P 500 began its pullback at 4,600 with a bearish engulfing candlestick on Thursday, July 27. (For reference, bearish engulfing candlesticks are often found after upward price moves and suggest a shift to supply overwhelming demand.) At that time, the index was trading at around a 12% premium to its 200-day moving average (dma), marking over two standard deviations above average, while nearly 20% of index constituents were also overbought based on their Relative Strength Index (RSI). While overbought does not mean over, we suspect this could be a logical spot for a pause or a pullback in this rally, especially as the market enters a weak seasonal period.

View enlarged chart

In terms of downside, support for the S&P 500 sets up at 4,450 (June highs), 4,432 (50-dma), and near the 4,200-4,300 range (uptrend/prior highs). We suspect the latter support range to be the most likely spot for a bounce given the confluence of support in this area, the degree of record-high cash sitting in money market assets, and the fact many investors missed the first half rally. We view the 200-dma as a worst-case scenario for a drawdown.

Bull Markets are not Linear

While there is overwhelming technical evidence supporting the case for a sustainable bull market, expect some pullbacks along the way. The table below compares annual price performance and maximum drawdowns for the S&P 500. At a high level, the chart shows that even years with double-digit gains often experience double-digit drawdowns.

To break down the data, we decile ranked annual price returns of the S&P 500 going back to 1950. The top or first decile represents the top 10% of all years based on price gains, while the bottom or tenth decile reflects the bottom 10% of all years for the index. The percentage thresholds for each decile group are also labeled for reference. After ranking each year by performance, we calculated each decile group’s peak-to-trough average maximum drawdown. We found that the average maximum drawdown for all years going back to 1950 is -13.8%. Furthermore, even years with well above-average price gains are not immune to sizable pullbacks, as the top decile groups reported drawdowns of around 10% on average.

View enlarged chart 

With the S&P 500 up 16.4% year to date (as of August 10), this year stands out as a top quintile year for performance thus far. Despite the strong momentum, we found other years with above-average gains during this stretch still experience sizable drawdowns into year-end.

The table below breaks down the S&P 500 based on decile-ranked performance from December 31 to August 11. The subsequent average returns and maximum drawdowns for each decile group are also highlighted for the August 11 to December 31 timeframe. In short, history suggests a 5-10% drawdown between now and year-end is not uncommon, even during solid rallies into August. However, even after a drawdown, the S&P 500 has still historically generated positive average returns into year-end.

View enlarged chart

SUMMARY

Stocks have pulled back modestly this month as overbought conditions met overhead resistance. Interest rate volatility, monetary policy uncertainty, stretched valuations, and underwhelming economic data in China have also weighed on risk appetite. While there is still strong support for stocks being in a sustainable bull market, we suspect odds for a pullback in this rally are increasing. However, don’t panic, pullbacks are normal, even during years with above-average returns. History suggests a 5-10% drawdown between now and year-end is not uncommon. And even with a drawdown, the S&P 500 has still historically generated positive average returns into year-end.

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