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Opportunity amid the pullback

Key takeaways

  • The recent selloff was sparked by job-market numbers that appear poor. But under the surface the US employment market continues to show strength.
  • Discrepancies in certain market fear indicators could be sending clues that the stock market's recent decline was an overreaction.
  • Putting all the evidence together, I believe this has been a sharp drawdown in the middle of a broader uptrend, and that it's likely not a signal of a looming recession.
  • If that's the case, this could turn out to be an opportune time to consider certain sectors and segments that are loaded with catch-up potential. Among them: interest-rate sensitive and small- and mid-cap stocks.

There’s an old saying that investors should try to be fearful when others are greedy, and greedy when others are fearful. While market developments in the past week certainly had some investors understandably nervous, a closer look at the data suggests that this might be a time for getting in, not out.

My research focuses on analyzing market history to uncover patterns and probabilities that can help challenge investors’ biases and provide a more objective foundation for investment decisions.

Currently, my research suggests that the market’s recent stumble was likely a normal temporary pullback in the middle of a longer-term uptrend. More market stumbles are always possible—particularly over the short term, which is notoriously impossible to predict. But for investors who can look past any near-term bumps, this could prove to be an opportune time to get into certain segments and sectors with catch-up potential.

Here’s more on my 3 biggest takeaways for investors right now, including where I see the strongest opportunity potential.

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1. The job market may be stronger than it looks

Let’s start by unpacking the main economic news that sparked the selloff. The first sign of potential weakness came from a reported slowdown in a manufacturing employment index.1

The second sign came from unemployment data, which showed the US unemployment rate increasing to 4.3% in July (up from 4.1% the previous month).2 Taken together these data points sparked investor worries that unemployment could be not just rising but accelerating, and that the US might be irrevocably headed for recession.

News reports on the “Sahm Rule” might make it sound like a recession is now unavoidable.3 But in truth, the causes behind an unemployment uptick matter. In a recession, unemployment typically goes up because companies are using fewer workers (i.e., they lay people off and do less hiring). But the recent uptick has been almost entirely driven by more people coming into the labor force. In fact, labor-force participation among the 25 to 54 age range hasn’t been this high in decades.

Chart shows labor participation rate among 25 to 54 year olds, showing the rate is now close to its all-time high.
Source: US Bureau of Labor Statistics, retrieved from FRED, Federal Reserve Bank of St. Louis. Data as of August 6, 2024.

In recessions it’s more common to see the reverse, with job seekers becoming frustrated and leaving the workforce. It’s not impossible—but it is relatively rare—to see labor-force participation increase in the lead-up to a recession.

Moreover, in the bigger picture the key driver of the labor market is corporate earnings. If employers are making healthy profits, they generally aren’t laying off workers. Second quarter earnings recently looked on track to notch double-digit growth, and I believe profits may continue to accelerate from here. Rising profits could keep supporting the labor market, in a virtuous circle that also helps support the economy and stock market.

Chart shows that earnings estimates have been strong and showed continued acceleration.
Past performance is no guarantee of future results. Estimated earnings per share represent consensus analyst estimates for S&P 500 constituents for following 12-month period. Source: FactSet. Data as of August 5, 2024.

2. Market signals suggest we’re not entering a recession

To be sure, the recession question is vitally important for investors. The 6-month periods heading into recessions have historically been some of the worst times to be in the market, with it often taking years for investors to recover. Non-recessionary pullbacks—i.e., when the market corrects even though the economy continues to expand—have historically been much less severe, with investors recovering in a matter of months.

While earnings have been giving some clues on economic fundamentals, I also like to look for signals in the market data itself. One key signal I noticed in the past week was the rapid rise in the VIX, an index of implied volatility that’s also a useful yardstick for the level of fear in the stock market. While intuition would suggest that a steeper rise in the VIX signals a higher likelihood of recession, in fact the opposite has historically been true (perhaps a sign that extreme fear reactions in the market are more often overdone, compared with more moderate fear reactions).

I turned up an even stronger signal by comparing fear in the stock market with fear in the bond market, which investors often measure with changes in credit spreads. Credit spreads measure the amount of additional yield that investors demand in exchange for taking on credit risk, such as with high-yield bonds. When investors become more worried about economic conditions, they demand more yield for taking on credit risk, so credit spreads increase. While credit spreads did increase in the bond market in the past week, they increased by much less than the jump seen in the VIX.

In other words, the stock market has looked much more worried in the past week than the bond market. Historically, more than 80% of the time, big discrepancies in those fear indexes like what we saw in the past week corresponded with a non-recessionary market pullback. And in 100% of historical periods with similar dynamics in those indexes, the stock market went on to advance over the following 12 months (though past performance is no guarantee of future results).

To put it very simply, when the stock market panics but the bond market doesn’t, often the bond market turns out to be right. (Another old saying in investing is that sometimes, the bond market is smarter than the stock market.)

3. Investors might look back and see this as a buying opportunity

There are no certainties in the market, but based on the evidence, I believe this period will most likely turn out to be a steep pullback in the middle of a broader uptrend. Historically, that has actually been a positive signal for stocks’ subsequent performance. And if I had to choose between battening down the hatches or pursuing opportunity, I would use this moment to pursue opportunity.

In my opinion, there are 2 main areas where the strongest potential opportunity might lie:

Interest-rate-sensitive sectors

Specifically, the real estate and financial sectors look potentially compelling. Sectors that are sensitive to interest rates, such as these 2, usually lead in the run-up to a first rate cut. This year has been unusual because these sectors have instead lagged (in fact, performing roughly the way I might expect before an interest rate hike). Both sectors also have shown low valuations, which may provide a margin of safety and indicate that the sectors are pricing in too much bad news. If or when the Fed does cut rates, as the market is expecting for September, these sectors could see strong catch-up potential.

Small- and mid-cap stocks

The dynamics at play in the market this year, with earnings accelerating and the Fed poised to start cutting rates, have historically provided a positive environment for small- and mid-cap outperformance. At the same time, the valuation gap between large companies and small- and mid-sized companies has rarely ever been so wide. Like gradually stretching a rubber band, these factors have loaded small- and mid-cap stocks up with catch-up potential.

In conclusion

Markets don’t go up in a straight line. Market corrections and steep pullbacks always feel like a panic. But in fact they’re very common. Historically since 1962, most calendar years have included at least one market pullback of 5% to 15%. There’s always a reason for them, at the time, and yet they are normal and healthy corrections.

Many investors may reasonably ask, “But what if it’s different this time?”

To which I’d ask in response: But what if it’s not?

Denise Chisholm, Sector Strategist, Fidelity
Denise Chisholm
Director of Quantitative Market Strategy

Denise Chisholm is director of quantitative market strategy in the Quantitative Research and Investments (QRI) division at Fidelity Investments. Fidelity Investments is a leading provider of investment management, retirement planning, portfolio guidance, brokerage, benefits outsourcing, and other financial products and services to institutions, financial intermediaries, and individuals.

In this role, Ms. Chisholm is focused on historical analysis, its application in diversified portfolio strategies, and ways to combine investment building blocks, such as factors, sectors, and themes. In addition to her research responsibilities, Ms. Chisholm is a popular contributor at various Fidelity client forums, is a LinkedIn 2020 Top Voice, and frequently appears in the media.

Prior to assuming her current position, Ms. Chisholm was a sector strategist focused on sector strategy research, its application in diversified portfolio strategies, and ways to combine sector-based investment vehicles. Ms. Chisholm also held multiple roles within Fidelity, including research analyst on the mega cap research team, research analyst on the international team, and sector specialist.

Previously, Ms. Chisholm performed dual roles as an equity research analyst and director of Independent Research at Ameriprise Financial. In this capacity, she focused on the integration of differentiated research platforms and methodologies. Before joining Fidelity in 1999, Ms. Chisholm served as a cost-of-living consultant for ARINC and as a Department of Defense statistical consultant at MCR Federal. She has been in the financial industry since 1999.

Ms. Chisholm earned her bachelor of arts degree in economics from Boston University.

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1. "Manufacturing PMI® at 46.8%; July 2024 Manufacturing ISM® Report on Business®," Institute for Supply Management, accessed on August 5, 2024, www.ismworld.org/supply-management-news-and-reports/reports/ism-report-on-business/pmi/july/. 2. "The Employment Situation—July 2024," Bureau of Labor Statistics, US Department of Labor, August 2, 2024, www.bls.gov/news.release/pdf/empsit.pdf. 3. The "Sahm Rule" describes a historical statistical relationship in which a 0.5 percentage point or greater rise in the 3-month moving average of the US unemployment rate, relative to its low in the previous 12 months, has typically preceded a recession. References to specific securities or investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. This information must not be relied upon in making any investment decision. Fidelity cannot be held responsible for any type of loss incurred by applying any of the information presented. These views must not be relied upon as an indication of trading intent of any Fidelity fund or Fidelity advisor. Investment decisions should be based on an individual's own goals, time horizon, and tolerance for risk. This piece may contain assumptions that are "forward-looking statements," which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

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