US stocks could correct this summer. Here's why

A trader works on the floor of the New York Stock Exchange.
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A trader works on the floor of the New York Stock Exchange.

Stocks could correct this summer, but it won't be because the U.S. market is blindly following Germany.

Unlike the Treasury market which has been shadowing German bunds, the German DAX's more than 10 percent correction is not leading the way for U.S. stocks, strategists say.

"You've got (rising) rates. You've got the Fed. You have Greece. You have EM. You have illiquid times, which is summer. The sectors are showing less momentum, less rotation. Breadth is starting to deteriorate a little bit," said Jordan Kotick, head of cross-asset strategy at RBC.

"You've got a lot of risks this summer. We're still bullish equities," said Kotick, adding that emerging markets and some of the other triggers could be the catalyst for a selloff.

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The German stock market, as of Tuesday was down 11 percent since April 10 and while there is a tight correlation between bunds and bonds, the same can't be said for the DAX and the S&P 500.

Marc Chandler, chief currency strategist at Brown Brothers Harriman, said U.S. yields, in the past 60 days, have followed German yields 95 percent of the time.

Stocks, meanwhile have "a 54 percent correlation, which is the highest since January. We're at a four-month high," he said. Even after correcting, the DAX is still up 12 percent for the year, and it fell another 0.6 percent Tuesday. The S&P 500 is up just a little more than 1 percent for the year so far.

"I think maybe (German stocks) kind of overshot to the upside. It was such a strong move in the first quarter, where you had a lot of outperformance in the German DAX. Now some of that is coming back to trend. All along the U.S. has been flat," said Ari Wald, technical analyst at Oppenheimer Asset Management. "I want to see the German DAX come back and rally here. Now that we've had this 10 percent correction ... this looks like a healthy correction."

Wald doesn't see a U.S. correction and says the S&P should continue to grind higher, while individual groups correct. "You could still have this bifurcated performance ... I think the overall trend is intact as long as you're above 2,040. We think there's enough stocks in an uptrend to avoid a broad selloff in the stock market," he said.

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Wald said technology, financials and some cyclicals have performed well, but utilities and some interest rate-sensitive sectors have underperformed as the Fed gets closer to hiking rates.

Kotick said the two markets are connected by the fact that the European Central Bank's easing gave a boost to risk assets when it embarked on quantitative easing this year.

"Germany's been a focus. QE really ignited the whole thing. Without European QE, we'd be in a different position," he said.

Source: FactSet

He said investors are surprised by the fact that bund yields had been leading U.S. Treasurys during the recent violent selloff even though bunds have been leading for about 18 months. "Until you get the Fed in play, they're still being led by Europeans," Kotick said. Treasury yields rose in tandem with bund yields Tuesday, with the U.S. 10-year holding above 2.40 percent in the afternoon.

Some of the same factors affecting German stocks, however, will certainly affect U.S. stocks.

"Unless you think Greece is going to end in hugs, which I don't think it is, Europe will continue to dominate during the summer. The only thing I'll put in as a footnote is 'Keep an eye on emerging markets.' They got a triple whammy," he said.

Kotick said emerging market currencies and rates are under pressure, as they struggle against rising commodities prices, the stronger dollar, and higher yields in both Europe and the U.S.

"They're a laggard until they're aggressive. If they get aggressive, they go from being reactive to generally causing some fear ... I'm not looking for them to crash. I'm not looking for them to get aggressive. However this is a credit trade. If yields continue to sell off, there's likely to be some capital flows out of emerging markets, back into the United States."

As for U.S. stocks, he expects the S&P 500, at around 2,080 on Tuesday, to reach 2,170 to 2,200 by year-end. "I just think before you get up there, you're going to have a dip first," said Kotick.

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He said risks for stocks include the Fed, higher interest rates and Greece. "I think EM and some of these other triggers might be the catalyst" for a selloff, Kotick said.

Chandler said even though U.S. stocks aren't following the DAX tick by tick, the correlation is still fairly strong. "In 2010, 2011, 2012, we stayed between 60 and 80 percent (correlation). We fell below 40 percent this year ... and now we're coming back up. ... The correlation had broken down to multiyear lows. We're returning to more normal levels," he said.

Equities markets have different idiosyncrasies and regulations, and that makes the U.S. stock market less likely to follow German stocks, he said.

"You have one big capital market. The bond market is a better measure of how integrated the global markets are," he said.

"We're an equity market culture and they're not," said Chandler. "Because of historical divergences, equity markets are not typically as integrated as bond markets."