Buzz about summer stock slowdown heats up

With the Standard & Poor’s 500 stock index hitting a record in July and a tad pricey relative to history, some Wall Street pros are sounding the alarm about a potential summer pullback.

Angst is visible in headlines of recent Wall Street reports that deliver a message of short-term caution: “Testing time for the bull?” writes Gina Martin Adams, equity strategist at Wells Fargo Securities. “S&P summer sizzle: Don’t get burned,” warns David Bianco, strategist at Deutsche Bank. "Some reasons to expect August to be a down month,” adds Tom Lee of Fundstrat Global Advisors.

Yellow flags are as plentiful on Wall Street as yellow beach umbrellas along the U.S. coastline. The S&P 500's inability to make a fresh high so far this week could be signaling broader investor hesitancy. The benchmark index closed at 2170 Thursday.  That was 0.2% shy of its all-time high hit last Friday -- its first record close since May 2015.

None of the strategists above are calling for a steep decline or the end of the seven-year old bull market. But they are saying a market pause is possible. Most are advising clients to buy on any dip, as they expect stocks to move higher after any drop.

Lee sees the S&P 500 gaining 8% to 10% in the second half of 2016, but admits he’s “scared about the month of August.”

While new highs after a wait of a year or more tend to be bullish, historical performance data show the S&P 500 “tends to see a pause over the next month” after hitting a new peak, Lee says. Following 13 new peaks after year-long new-high droughts since 1954, the S&P 500 was up an average of just 1% a month later, vs. gains of 4% three months later and 12% returns a year later.

Also worrying Lee is the fact that normally placid bonds are currently more volatile than stocks. That uncommon relationship – which Lee says signals investor "complacency" -- has proved to be a “short-term negative” for stocks, with the S&P 500 declining 1.3%, on average, and down 68% of the time, a month later after similar periods.

Another yellow flag is August's recent reputation as a bad time for stocks, with the S&P 500  finishing lower four of the past six Augusts, with the declines often steep and scary.

Recent rumblings of a coming interest rate hike could also dent investor sentiment. There’s a risk Wall Street will be caught off guard by an earlier-than-expected rate increase from the Federal Reserve. In a statement Wednesday the Fed said: "Near-term risks to the economic outlook have diminished." That opened the door to a hike as early as September, analysts warn.

However, the very weak 1.2% economic growth for the second quarter released Friday by the government could keep the Fed on hold longer as it suggests the economy remains stuck in the doldrums. Wall Street had been expecting GDP growth in the April thru June quarter to come in at 2.6%.

"The rally now is being supported by one prop – no Fed tightening," says Nick Sargen, senior investment advisor at Fort Washington Investment Advisors. "If the Fed finally moves later this year, I would expect a noticeable correction (or stock decline)."

Another potential headwind: The corporate earnings season, which is now hitting its busiest and most important period, says Adams.

“The real earnings test is yet to come for stocks,” she says, adding that investor optimism is getting more bullish and nearing levels that in the past have signaled market tops.

Deutsche Bank's Bianco warns that stocks could suffer a dip of 5% to 9% in the run-up to the presidential election in November, due to risks related to corporate earnings and rising stock valuations.

The S&P 500 is trading at 18.3 times its trailing 12-month earnings, the highest level since November 2004, according to Burt White, chief investment officer at LPL Financial. “Stock market corrections tend to be more painful when they come at higher valuations,” White noted in a report, adding that most bull markets since World War II have ended at P-E levels similar to today's.