is about to pull off its best first half of a year in at least 10 years and the Dow Jones Industrial Average is having its best June since 1938, but underneath this impressive rally is a trend that doesn't seem quite right, according to J.P. Morgan.
From consumer discretionary to technology, cyclical stocks that typically are tied to economic growth have failed to regain the ground lost in May, whereas only defensive groups like consumer staples and utilities have confirmed the S&P 500's new highs, J.P. Morgan's chart analyst Jason Hunter pointed out.
"Rally leadership doesn't inspire a lot of confidence yet ... In our view, that cross-market divergence can only persist for a short period of time, and the S&P 500 Index rally potential is limited under the current conditions," Hunter said in a note on Wednesday.
Indeed, the market's strong comeback in June has little to do with economic fundamentals. It's largely driven by the shift in Federal Reserve's monetary policy and the revived hopes for a trade deal between the U.S. and China. The persistent weakness in cyclicals stocks that traditionally correlate to economic health could be especially worrisome as the corporate profit picture continues to deteriorate.
The S&P 500 consumer discretionary sector has consistently lagged the S&P 500 consumer staples sector ever since last October. For the bull run to last, cyclicals have to take the lead in the rally, according to the analyst.
"We do not believe the divergence between Cyclicals and Defensives can persist if the S&P 500 Index is set to extend the rally through the summer. In our view, either cyclical markets need to start outperforming and take the leadership role in a rally, or the broad equity market is vulnerable to a material setback," Hunter said.
Another area of the market that's raising a red flag is small caps, which are also typically related to economic growth. The Russell 2000 has not only extended its year-long underperformance but has also fallen further behind the broad market. The index fell into correction territory in May as investor dumped riskier stocks amid the intensified trade tensions.
From a technical standpoint, until the small-cap index's relative performance starts to improve or 'the market breaks through the 1,600 area resistance zone, it's hard to have high conviction in a positive outlook," Hunter said. The index currently trades at around 1,519.