Stocks are in for a volatile summer. A deeper pullback may be ahead, strategists say

Published Tue, Jul 20 20212:05 PM EDTUpdated Tue, Jul 20 20212:20 PM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

Even with Tuesday's snapback rally, some strategists expect a volatile summer with more selling ahead. Stocks bounced Tuesday after Monday's sharp sell-off on fears that Covid variants will hurt the reopening economy. Many of the stocks hit hardest bounced back Tuesday, with cyclicals, like airlines, industrials and bank stocks all gaining. Some strategists see the market heading into a volatile period, in which there could be a deeper pullback which will not end the bull market. Play defense "The defensive playbook is the playbook that works right now, when you get this kind of sell-off that's virus-related and macro-related concerns," said Julian Emanuel, head of equity and derivatives strategy at BTIG. "Even with yields beginning to stabilize, the concern about the virus is probably weeks away from stabilizing. And even when that happens, you have a huge amount of underlying inflation." The Dow surged more than 600 points Tuesday afternoon, after falling 725 points Monday. The S & P 500 jumped 1.6%. The closely-watched benchmark 10-year Treasury yield was at 1.20%, reversing a move that took it to a low of 1.12% early Tuesday. "We've seen days like this," said George Goncalves, MUFG head of U.S. macro strategy. "It's a bad volatility environment... August is not the best month. Whenever we have a July rally in bonds, typically we have another one in August." The 10-year yield, which moves opposite price, was as high as 1.48% at the beginning of July. Bond pros had expected rates to rise, but instead they fell on a variety of concerns, including fears that the Federal Reserve would move too quickly to end easing policies. Emanuel said the S & P 500 could see a decline of more than 5%, but it could also be as much as 10% or more. He expects the S & P 500 to touch 4,000 or even the 200-day moving average, currently 3,899, before the end of September. Some strategists have been anticipating a correction, meaning a decline of 10% or more, but the market has periodically shrugged off shallower pullbacks as dip buyers rushed in. "I think what we've seen here are the early warning shots of a correction that we'll see probably... in late August, September, October," said Matt Maley, equity strategist at Miller Tabak. "We're starting to see some signs of it. The fact the semiconductors can't seem to break out is a concern." Stock investors have been focused on the unusual move in the 10-year yield, expected to be on an upswing to a level of 2% or higher this year. Up until recently, when yields were moving lower, tech and growth stocks did better. But falling yields have now become worrisome for stocks because investors see the bond market as signaling the potential for a global growth slowdown. Even as the 10-year steadied Tuesday, market chatter still focused on whether the 10-year was bottoming or could slide lower again to reach 1%, a level strategists say is unlikely but would spook the stock market. "It's not a pretty chart the way the momentum looks. It's a 'catching a falling knife' kind of thing. It is an extended market," Goncalves said of the 10-year yield. "It wouldn't be unusual to see it bounce back to 1.20%. Is that the end? I'm not going to make that call. This market is not operating on fundamentals. I think it's almost done. This is an overshoot market." Besides the bond market, strategists have been watching the behavior of the Russell 2000, which had been falling recently and was as much as 10% from its high during Monday's sell-off. The index outperformed Tuesday, gaining more than 2% after Monday's decline of 1.5%. "Small caps are ground zero for this whole labor market dynamic," said BTIG's Emanuel. "They've been horrible after having been the market leader for basically the first 12 months of the rally. We continue to think the cyclical areas are the ones you want to own — small caps, energy, financials — once there's a sufficient amount of fear in the market." Emanuel said both small caps and transports, which also have been selling off, need to bottom. "We're going to want to see tech sell off in terms of capitulation," he said, adding that the tech sector's gains are again too concentrated in a few big names. Emanuel said he's been recommending investors use options, both to hedge against a sell-off and capture upside. He's also focused on defensive stocks, like consumer staples and health care. "We basically like a broad swath of companies that can pass along higher prices to customers," he said. On the BTIG list are Coca-Cola , Altria , PepsiCo, and Procter and Gamble. Emanuel also said he favors Big Pharma in health care. "Basically, you've got yield. You've got earnings certainty, and the stocks have been cheap," he said. Johnson & Johnson was up over 1% Tuesday, and Pfizer climbed more than 2%. Eli Lilly and Bristol-Myers Squibb were less than 1% higher.

Traders on the floor of the New York Stock Exchange.

Source: NYSE

Even with Tuesday's snapback rally, some strategists expect a volatile summer with more selling ahead.