It feels bad, doesn’t it? Even though the market slipped only a little this past week, the bears are rejoicing like it was 1999. The first five months of this year have been one of those rare market moments that harken back to the mid-90s, when equities relentlessly rallied. Now comes a little cold water.

Since May 3, at one point the S&P 500 was down about ~5%, or ~125 points, the deepest such pullback since the awful days of December. Naturally, investors are asking themselves has this pullback done sufficient damage to signal a major top?

I’m of the opinion that May 3’s level of 2945 isn’t the high for the year, as stocks seem to have pulled back more severely than investment grade and high-yield bonds. To me, the fact that credit activity is more muted suggests the trade tensions/tariffs are having transitory impacts. More specifically, risk off has raised equity premia but not severely raised the risk of default.

This can be seen quite clearly within the investment grade credit default swaps arena. Technology, industrial and financial stocks have been among the hardest hit, thanks, in part, to exposure to the China-U.S. trade and tariff tiff, but corresponding credits are not reacting as badly.

Nevertheless, deeper technical damage has been done to markets than the pullbacks seen earlier in 2019. Consequently, time will be needed to heal these wounds.

The next few months of trading might see some “choppy” action, as markets and investors attempt to fully price in tariffs and the risks of escalation against the probability of a resolution of these issues. This doesn’t change my expectation for the S&P 500 to reach 3,100 by yearend 2019.

Don't Be Swayed By Risk Off Fears: Rally Looks Intact
Don't Be Swayed By Risk Off Fears: Rally Looks Intact

Another interesting indicator is that sentiment is also arguably bottoming. The American Association of Individual Investors AAII reading of the percentage of bulls less the percentage of bears was -9% in the past week. (See chart on the right.)

That’s the worst level in all of 2019 and one surpassed only during by the dark weeks around the Federal Reserve meeting in November and resulting market collapse. In my view, the AAII is one of the most reliable measure of investor sentiment. This reading suggests that the bad news seems baked in.

What could go wrong?

There remains a risk that a major top was put into the equity market this month and that the trade war leads to a recession. However, such a risk is low and more than offset by the higher probability of a massive risk-on rally. Perhaps we’ll see FOMO again. I continue to believe that upside this year will be driven by both an expansion in the market price/earnings (P/E) ratio and by earnings per share (EPS) revisions.

Bottom line: During this period of choppy action, investors should stick with FS Insight’s Granny Shots, which are culled from portfolios constructed with FS Insight long term themes applied to company fundamentals and other factors. (For more on how Granny Shots are chosen and these themes, please see the May 11 edition.) They represent the “best of the best,” so to speak. Granny Shots have outperformed the S&P 500 index by 4.3% so far this year since January 10.

The tickers are : GOOG, AAPL, TSLA, BKNG, XLNX, PM, AMGN, FB, GRMN, NKE, LOW, AMZN, EBAY, ROK, CSCO, PYPL, KLAC, NVDA, QCOM, PSX, AMP, AXP, BF/B, MNST, MO, VAR and DIS.

Don't Be Swayed By Risk Off Fears: Rally Looks Intact
Figure: Comparative matrix of risk/reward drivers in 2019
Per FS insight
Don't Be Swayed By Risk Off Fears: Rally Looks Intact
Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/10/2019

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