by Scott Martindale
CEO, Sabrient Systems LLC
Overview
The full pullback/correction I have been anticipating remains elusive. After all, stocks can’t go straight up forever, and this bull run has become long in the tooth. The greater the divergence, the worse the potential correction. Ever since the market recovered from its April “Liberation Day” tariff-driven selloff, every attempt at a correction or consolidation has been quickly bought before it could get started. But last week seemed different. It was Nasdaq’s worst week since April, and all the AI-driven market exuberance seemed to have suddenly shifted to fears of a valuation bubble. Alas, fear not. It seems to have been nothing more than another brief pause to refresh—i.e., take some profits off the table, reassess fundamentals versus sentiment, shake out the weak holders (including momentum traders), test technical support levels, and shore-up bullish conviction…punctuated by a nice bounce off the 50-day moving average.
Even on October 10, when the S&P 500 fell 2.7% on President Trump’s announcement of massive tariffs on Chinese imports and China’s retaliatory export restrictions on rare earth elements, the market began its recovery the next day. Besides Big Tech, speculative “meme” stocks were also hot. And to further illustrate the speculation, the Russell Microcap Index (IWC) has been performing in line with the S&P 500, setting a new all-time high in October (for the first time since 2021). It is notable that the lower-quality Russell 2000 Small-cap Index (IWM), in which over 40% of the companies in the index are unprofitable, has been substantially outperforming (+10.6% vs. +4.3% YTD) the higher-quality S&P 600 SmallCap (SPSM), in which all stocks are required to show consistent profitability for index admission.
So, it was only a matter of time for bears to try again to push the market lower, especially given the growing set of headwinds (described in my full commentary below). During last week’s selloff, we saw the CBOE Volatility Index (VIX) surge above 20 (fear threshold) as traders deleveraged. Bitcoin dropped below $100,000 for the first time since June (a 20% correction from its all-time high in October). The CNN Fear & Greed Index dipped into Extreme Fear category. State Street’s Risk Appetite Index showed Big Money refraining from risk assets for the first time since mid-May. And Warren Buffett’s Berkshire Hathaway’s (BRK.B) cash reserves hit yet another record high of $382 billion, as valuations had become too pricey for the “Oracle of Omaha.” But at its low last Friday, the S&P 500 was only down about 4.2% from its peak.
Market breadth remains a concern. While the mega caps kept rising, we have seen only occasional glimpses of nascent rotation, including this week in which the Dow Industrials (DIA), Dow Transports (IYT), and equal-weight S&P 500 (RSP) have all significantly outperformed the S&P 500 and Nasdaq 100. But each prior attempt this year at broadening across sectors and market caps has been short-lived. Only 22% of active fund managers are beating their passive benchmark. Investech noted that from an historical perspective, the Nasdaq Composite has hit a new all-time high with 2:1 negative breadth (decliners/advancers) only twice in its 54-year history—once just prior to the 2022 bear market and once several days ago. Notably, bitcoin and other cryptocurrencies corrected much more sharply than stocks, mostly due to deleveraging, and have not yet bounced back like stocks have. Nevertheless, blockchain, tokenization, and stablecoin implementation continue to progress, so I’m not concerned about my crypto allocation.
The S&P 500, Nasdaq 100, and Dow Jones Industrials each successfully tested support at their 50-day moving averages and then quickly recaptured and retested support at their 20-day moving averages this week as the government shutdown moved toward resolution. But leadership this week has noticeably swung to the Dow Industrials (notably, not cap-weighted), which is the first to get back above its all-time high, and the Dow Transports are getting close, which according to Dow Theory would confirm the bull market. Also, the small-cap Russell 2000 is on the verge of recovering its 20-day average. Notably, gold, silver, and copper have also recovered above their 20-day moving averages and seem bent on reaching new highs.
In essence, I would characterize the latest pullback as a passing “macro scare” within a structural bull market, with some promising new signs of healthy market rotation, and I still think the S&P 500 will achieve another 20%+ return for 2025—for the third year in a row, which would be only the second time in history other than the 5-year (1995-99) dotcom/Y2K bull run.
So, looking ahead, should we expect all rainbows, unicorns, blue skies, and new highs through 2026? Well, while there surely will be more macro scares, more consolidation, and more retests of bullish conviction ahead of the seasonal Santa Claus rally, I believe the fundamental tailwinds greatly outweigh the headwinds, as I discuss in my full commentary below. The government shutdown is over, at least until the end of January. Investors remain optimistic about AI capex and productivity gains, a trade deal with China, a more dovish Fed, business-friendly fiscal policies, deregulation, fast-tracking of power generation infrastructure and strategic onshoring, a stable US dollar, and foreign capital flight into the US (capital tends to flow to where it is treated best). And lower interest rates will lead to more consumer spending, business borrowing for investment/capex, earnings growth, and stock buying (including retail, institutional, and corporate share buybacks). Indeed, the 10-2 Treasury yield spread stands at about 50 bps today, which is consistent with past periods of continued US economic expansion.
However, while retail investors have continued to invest aggressively, institutional investors and hedge funds (the so-called “smart money”) have grown more defensive and deleveraged. So, maintaining a disciplined approach—such as focusing on fundamental analysis, long-term trends, and clear investment goals—can protect against emotional kneejerk overreactions during murky or turbulent periods.
On that note, remember that stock valuations are dependent upon expectations for economic growth, corporate earnings, and interest rates, tempered by the volatility/uncertainty of each—which manifests in the equity risk premium (ERP, i.e., earnings yield minus the risk-free rate) and the market P/E multiple. Some commentators suggest that every 25-bp reduction in interest rates allows for another 1-point increase in the P/E multiple of the S&P 500; however, those expected rate cuts over the next several months might already be baked into the current market multiple for the S&P 500 and Nasdaq 100 such that further gains for the broad indexes might be tied solely to earnings growth—driven by both revenue growth and margin expansion (from productivity and efficiency gains and cost cutting)—rather than multiple expansion.
Broad, cap-weighted market indexes like the S&P 500 and Nasdaq 100 essentially have become momentum indexes, given their huge concentration in AI-driven, Big Tech mega-caps. So, although growth stocks and crypto may well lead the initial recovery through year end, longer term, rather than a resumption of the FOMO/YOLO momentum rally on the backs of a narrow group of AI leaders (and some speculative companies that ride their coattails), I expect the euphoria will be more tempered in 2026 such that we get a healthy broadening and wider participation across caps and sectors and with a greater focus on quality and profitability. There are plenty of neglected high-quality names out there worthy of investment dollars.
As I discuss in my full commentary, top-ranked sectors in Sabrient’s SectorCast model include Technology, Healthcare, and Financials. In addition, Basic Materials, Industrials, and Energy also seem poised to eventually benefit from fiscal and monetary stimulus, domestic capex tailwinds, a burgeoning commodity Supercycle, rising demand for natural gas for power generation, and more-disciplined capital spending programs.
As such, although near-term market action might remain risk-on into year end, led by growth stocks, the case for value stocks today might be framed as countercyclical, mean reversion, portfolio diversification, and market broadening/rotation into neglected large, mid, and small caps, many of which display a solid earnings history and growth trajectory as well as low volatility, better valuations, and less downside risk, with greater room for multiple expansion. On 10/30, I published an in-depth post detailing the case today for value investing titled, “Is the market finally ready for a value rotation?” in which I discussed three key drivers: 1) mean reversion on extreme relative valuations, 2) diversification of portfolios that have become heavily titled to growth, and 3) sticky inflation benefiting real assets and cyclical/value sectors. So, perhaps the time is ripe to add value stocks as a portfolio diversifier, such as the Sabrient Forward Looking Value Portfolio (FLV 13), which is only offered annually as a unit investment trust by First Trust Portfolios and remains in primary market only until Friday, 11/14.
In addition, small caps tend to benefit most from lower rates and deregulation, and high-dividend payers become more appealing as bond alternatives as interest rates fall, so Sabrient’s quarterly Small Cap Growth and Dividend portfolios also might be timely as beneficiaries of a broadening market—in addition to our all-seasons Baker’s Dozen growth-at-a-reasonable-price (GARP) portfolio, which always includes a diverse group of 13 high-potential stocks, including a number of under-the-radar names identified by our models.
So, rather a continued capital flow into the major cap-weighted market indexes, which are dominated by mega-caps, growth, and technology, a healthy market rotation would suggest equal-weight, value, dividend, strategic beta, factor-weight, small/mid-caps, other sectors, and actively managed funds. Indeed, I believe we are being presented with an opportunity to build diversified portfolios having much better valuations and less downside than the S&P 500. In actively selecting diversified stocks for our portfolios (which are packaged and distributed as UITs by First Trust Portfolios), Sabrient seeks high-quality, undervalued, often under-the-radar gems for our various portfolios—starting with a robust quantitative model followed by a detailed fundamental analysis and selection process—while providing exposure to value, quality, growth, and size factors and to both secular and cyclical growth trends.
The Q4 2025 Baker’s Dozen launched on 10/17 is off to a good start, led by mid-cap industrial Flowserve (FLS) among its 13 diverse holdings, as is our annual Forward Looking Value 13 portfolio, led by mid-cap rideshare provider Lyft (LYFT) among its 28 diverse holdings. In fact, most of our 20 live portfolios are doing well versus their relevant benchmarks. And for investors concerned about lofty valuations and a potential spike in market volatility, low-beta and long/short strategies might be appropriate, such as the actively managed First Trust Long-Short ETF (FTLS), which licenses Sabrient’s proprietary Earnings Quality Rank (EQR) as a quality prescreen.
You can find our EQR score along with 8 other proprietary factors for roughly 4,000 US-listed stocks in our next-generation Sabrient Scorecards, which are powerful digital tools that rank stocks and ETFs using our proprietary factors. You can learn more about them by visiting: http://HighPerformanceStockPortfolios.com.
In today’s full post, I discuss in greater depth this year’s speculative rally and mega-cap leadership, whether the AI trade has gotten ahead of itself, market headwinds versus tailwinds, inflation indicators (in the absence of government data), and reasons to be optimistic about stocks. I also reveal Sabrient’s latest fundamental-based SectorCast quantitative rankings of the ten U.S. business sectors, current positioning of our sector rotation model, and several top-ranked ETF ideas.
Click HERE to find this post in printable PDF format, as well as my latest Baker’s Dozen presentation slide deck and my 3-part series on “The Future of Energy, the Lifeblood of an Economy.” As always, I’d love to hear from you! Please feel free to email me your thoughts on this article or if you’d like me to speak on any of these topics at your event! Read on….
