Why a Bremain relief rally can't send stocks to new highs

Markets are betting that the United Kingdom votes to remain in the European Union, and they're expecting a remain victory to send stocks higher. But Thursday's exuberant rally indicates that positive sentiment may be too much, too soon, and that stocks still have a tough road to setting and holding new record highs.

"You've got an unwind of a defensive trade that is probably enough to move the S&P to the upper range of the last 12 months," said Art Hogan, chief market strategist at Wunderlich Securities. He and other analysts expect beaten-down sectors such as financials to benefit from a risk-on rotation out of defensive-focused sectors such as utilities if Britain votes to stay in the EU.

The long-awaited results of the EU referendum are expected overnight, and should tip the balance in favor of remain, according to everyone from traders to betting markets. A YouGov opinion poll released after the end of voting in the U.K. pointed toward the remain vote prevailing with 52 percent, versus the leave vote's 48 percent. But anxiety over the U.K.'s place in the EU isn't the only thing that's been holding back stocks.

A pedestrian looks at prices displayed on digital screens at a foreign currency exchange bureau in London, U.K., on Wednesday, June 22, 2016.
Simon Dawson | Bloomberg | Getty Images

"Brexit has been an overhang, but it's not the overhang that's kept the S&P from breaking to a new high," Hogan said.

The S&P 500 closed about 1 percent below its all-time intraday high hit in May 2015 with a nearly 28-point gain to 2,113 on Thursday. That marked the highest close in two weeks, when the S&P was near its highs of the year so far. The run toward record highs was quashed last week by growing Brexit worries.

A recovery in momentum for "remain" has brought stocks back toward their record highs. That doesn't mean they can necessarily break well past them soon — stocks have hovered just below highs for months, and the S&P ended 2015 essentially unchanged.

The biggest reason for the sideways churn is lack of economic growth. S&P 500 earnings are set to post their fourth-straight quarter of declines in the second quarter.

"The market is trying to establish new highs and hold those highs. I think for that to happen … you need to see some positive follow-through from U.S. economic data and companies, improving topline revenues from companies," said Thomas Wilson, managing director of wealth advisory at Brinker Capital.

Questions about the U.S. Federal Reserve's intent with regard to interest rates in the near future has also kept stocks on edge. Analysts said if the results of the EU referendum show the expected remain result, investors' focus will shift to the June jobs report due in two weeks, the timing of the next rate hike and the U.S. presidential election.

"I'm not sure anything will put July back on the table [for a rate hike], but any strength in the June jobs number [increases the] likelihood of September," said David Lafferty, chief market strategist at Natixis Global Asset Management.

Rising rates do help banks, which have struggled as the worst S&P performer for the year as the Fed has dampened the market's rate-hike expectations. A vote for the U.K. to stay in the European Union would also maintain the status quo for financials in that major market.

"We've certainly seen just the talk of the Brexit has been a really wet blanket on the financial sector," Lafferty said. "They've struggled under tighter regulations. Now they're going to struggle under regulatory uncertainty."

To be sure, the recent recovery in U.S. stocks would amplify any likely sell-off following a British vote to leave the EU, particularly after an overnight reaction in European stocks.

"In the U.S., markets have survived several expected and unexpected events over the past few years that test the system," Spencer Mindlin, analyst at financial research and consulting firm Aite, said in an email. "However, other than the Swiss unpegging the franc from the euro in 2015, European markets have not been subjected to many events of this magnitude."

European shares have seen greater pressure than U.S. stocks have from sluggish growth and Brexit fears. The S&P 500 is up nearly 3.4 percent for the year so far, while the U.K.'s FTSE 100 is up 1.5 percent year to date, and the German DAX is down 4.5 percent year to date.

Analysts also said that generally, a very narrow, or roughly less than 5 percent, margin of victory for the remain camp over leave would likely keep uncertainty at the forefront. Growing European nationalism outside of the United Kingdom could result in another referendum, or an effort by another member nation to leave.

Pound sterling hit fresh highs for the year so far against the U.S. dollar and was last near $1.498. The U.S. dollar index was about 0.3 percent lower and the euro near $1.139, and the yen near 106.4 yen versus the greenback.

On Friday morning, scheduled U.S. economic data due include May durable goods orders, expected to show a half percent decline according to analysts polled by Reuters, and final University of Michigan June consumer sentiment, forecast to come in at 94.

The scheduled afternoon weekly oil rig count will be watched for indications on U.S. crude production levels. Traders also noted likely higher-than-normal trade volume Friday due to a Russell index rebalancing that's scheduled to take effect after the close.