Stocks are headed for a ‘summer squall,’ Citi warns

Stocks are headed for a ‘summer squall,’ Citi warns

U.S. stocks could be headed for a “summer squall,” according to a Citigroup equity strategist, who rattled off a handful of reasons why markets might face a pullback in this historically quieter period for markets.

To be sure, Citigroup’s Scott Chronert still expects the S&P 500 to finish the year at or around his target of 5,600, which he debuted in June as Wall Street scrambled to keep pace with a relentlessly rising index.

But in his latest report from Friday, Chronert said he expects a few bumps along the way.

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Valuations top Chronert’s list of potential sources of instability for stocks, given levels that remain rich relative to history. High valuations have typically impeded forward returns, according to Citi’s analysis.

The large-cap index’s forward price-to-earnings ratio, which measures how much investors are willing to pay per dollar of expected earnings over the coming year, currently stands at 21.1, above the 90th percentile from the past 40 years. The S&P 500 is even more richly valued on a trailing 12-month basis, Citi data show.

In the past, when valuations have been this stretched, the median one-year forward return for the index has been -4%.

So far, high valuations haven’t dimmed investors’ enthusiasm for stocks. Instead, a gauge of investor sentiment frequently employed by Citi analysts is pointing toward euphoria, while the Cboe Volatility Index, better known as the Vix or Wall Street’s “fear gauge,” is languishing near its lowest level since 2019. This suggests market could be primed for a burst of volatility if a negative catalyst arrives.

According to Chronert, a number of potential threats could loom ahead. Some standouts on his list included the upcoming 2024 U.S. election, the risk of another hotter-than-expected inflation print and geopolitical concerns, which spurred a brief selloff in stocks earlier this year.

As Chronert sees it, the only positive justifying further upside for stocks right now is the expectation that firms in the S&P 500 will continue to see earnings grow at a robust clip.

Citigroup’s tempered outlook arrived just as investors were about to enter what historically has been their strongest stretch of the calendar year on Monday. According to an analysis from Goldman Sachs Group, the first two weeks of July have typically coincided with a gain of more than 2% for the S&P 500.

But beyond that, things start to look a little more dicey. Over the past 50 years, the S&P 500 has typically seen seven daily declines of 1% or more during the summer months, according to an analysis from Ritholtz Wealth Management’s Callie Cox. The index hasn’t fallen by that much since April, which speaks to how calm markets have been lately.

If the index does make it until Labor Day without at least one such pullback, it would mark the most placid summer for stocks since 1979. According to Cox, low trading volume tends to exacerbate stock-market swings during the summer months.

However, while investors tend to take vacations during the summer months, there won’t be any such pause in potentially market-moving news, Cox said. Between July 1 and September, the market will need to navigate two jobs reports, a handful of inflation reports, a Federal Reserve decision on interest rates, and an earnings season that could see stocks struggle to meet an increasingly high bar on Wall Street.

There also have been growing jitters about a looming presidential election and economic data, which recently pointed to a cooling U.S. economy.

Major U.S. equity indexes started July off strong, with the S&P 500 up 0.1% to close at 5,475 on Monday, according to FactSet data. The Nasdaq Composite gained 0.8%.

The Dow Jones Industrial Average advanced 0.1%, while the small-cap focused Russell 2000 fell 0.8%.