A Summer Stock Market Rally Is Dangerous for Investors

July 5, 2020 3:30 PM UTC
Analysts say the stock market needs more time to trade sideways in order to avoid a massive correction in the fall.
  • The stock market’s sideways trading offers a necessary cooling-off period after a massive rally.
  • Q2 results could give investors reason for irrational optimism, pushing prices higher.
  • Another big rally this summer will likely end with a massive correction.

June was a bumpy month for the U.S. stock market. Wild swings in both directions kept equities trading mostly flat throughout the month for the first time since February. With second-quarter results due in July, many are wondering whether another rally could be in store. 

The S&P 500’s rollercoaster ride in June ended with overall equity prices relatively unchanged. | Source: Yahoo Finance

Stock Market Melt-Up

According to Wells Fargo’s Chris Harvey, a stock market melt-up could be on the cards. He says investors might take Q2 earnings beats to mean more than they do.

Earnings estimates for the second quarter are dismal. Many firms didn’t provide any guidance on their first-quarter earnings calls, which opens the door for upside surprises.

Harvey believes a sharp rally of more than 10% on the back of earnings is becoming an increasingly likely possibility. 

Here’s why that’s a bad thing.

Investors Overestimate Earnings Beats

FedEx’s results took the stock markedly higher despite the uncertainty ahead. | Source: Yahoo Finance

First, there’s the fact that earnings beats in Q2 don’t necessarily mean the stock market is out of the woods. Take FedEx (NYSE:FDX), for example. The firm’s early results gave market-watchers a taste of what’s to come.

The company delivered an upside surprise with EPS of $2.53 on revenue of $16.5 billion. Management noted that the pandemic hurt its business on every level and didn’t offer any forward guidance.

FedEx also revealed that it spent $125 million to outfit its workers in protective gear and up its cleaning and sanitation. The closure of its offices cost $370 million. 

Still, FDX stock rose 12% on the back of the news. Yes, FedEx outdid analyst expectations, but it also admitted near-term uncertainty and huge expenses.

A Stock Market Rally Only Inflates the Bubble More

Charles Schwab’s Randy Frederick says that if the rest of the stock market follows FedEx’s footprints, we could have an utterly dangerous melt-up:

I’d prefer that S&P 500 consolidate a little longer because another sharp rise is likely to be followed by another pullback.

Several analysts are cautioning that the S&P 500 is already wildly overvalued at current levels. Michael Kantrowitz noted that equity prices are still impossibly high right now: 

We’re still in irrational exuberance territory for equities

Irrational exuberance was a term coined by Alan Greenspan during the dot-com bubble. | Source: Investopedia

He noted that investors need to be picky when it comes to making investments as indexes have become overly inflated. The forward P/E for the S&P 500, for example, is not far from a multi-decade high.

Equity Prices Need Time to Cool Off

For investors like Kantrowitz, who see equities as overvalued, the kind of performance we saw in June is important for the stock market. By trading sideways, equities can cool down over time without delivering a considerable price drop.

The timing of a potential summer melt-up would be disastrous as well. Not only will autumn bring the uncertainty of the U.S. presidential elections sharply into view, but it could also coincide with a slew of worrying economic data. 

Initial unemployment claims fell sharply in May and June, but that could soon change as businesses close once again. | Source: Department of Labor

So far, U.S. economic data have been overwhelmingly positive. But the majority of that data reflects what has happened in the past. The encouraging employment data are a reflection of the past few months of economies reopening. Now that many states are starting to scale back their reopening plans and force businesses to close once again, the data will likely begin to worsen

Disclaimer: This article represents the author’s opinion and should not be considered investment or trading advice from CCN.com. The author holds no investment position in the above-mentioned securities.

Sam Bourgi edited this article for CCN.com. If you see a breach of our Code of Ethics or find a factual, spelling, or grammar error, please contact us.

Last modified: July 5, 2020 1:42 PM UTC

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