Market Extra: History shows stock market’s bullish momentum in the first half could spill over into the second half, but analysts are not so sure

The Nasdaq Composite
COMP,
+1.45%
gained 31.7% year to date, its best first half since 1983 and its third-best first half since its inception in 1971. The rally, led by megacap technology shares, has been spurred by the excitement around artificial intelligence software and hopes that the central bank is nearing the end of its interest-rate hiking cycle. 

The S&P 500
SPX,
+1.23%,
in which a small group of technology stocks account for almost all of the large-cap index’s 2023 rally, has jumped 15.9% this year. The Dow Jones Industrial Average
DJIA,
+0.84%
has lagged behind, up 3.8%, according to Dow Jones Market Data (see chart below). 

David Sekera, chief U.S. market strategist at Morningstar Research Services LLC, said the stock market in 2023 was the unwinding of some 2022’s headwinds, which included a tightening monetary policy, hot inflation, and a potential economic slowdown.

“In January of 2022, our outlook was that the equity markets at that point were overvalued and there were many headwinds that the market had to work through in 2022,” Sekera said. “The result is that all of those came to fruition over the course of 2022… And by the end of October, we thought the market was extremely undervalued.” 

In October 2022, the market was trading at a 23% discount to a composite of Morningstar’s intrinsic stock valuations, according to Sekera. Such a discount has only occurred one other time since 2010.

See: Stock-market investors close books on a wild first-half rally. Here’s how it stacks up.

If history is any indication, the stock market’s solid first-half momentum could spill over into the rest of the year. Since 1929, the S&P 500 index climbed an average of 4.3% in the second half when it rose at least 14% in the first six months of the year(see table below). For the Dow industrials, since 1897, when the index’s first half gains were 2% or higher, the gauge posted average gains of 6.2% in the second half, according to Dow Jones Market Data.

However, stock-market analysts remained cautious about what the history means for the markets moving forward. 

“Bull markets are not linear. Pullbacks and even a potential correction should be expected in the second half,” said Adam Turnquist, chief technical strategist at LPL Financial. “This is not a bold call but a reflection of history.” 

Since 1950, the average maximum drawdown for the S&P 500 during a calendar year has been negative 13.8%, well below this year’s current maximum drawdown of only negative 7.8%. Furthermore, positive first-half S&P 500 returns have historically led to shallower second-half drawdowns. For example, the average second-half maximum drawdown after a positive first half is negative 9%, as opposed to an average drawdown of negative 13.1% when the first half was negative, according to data compiled by LPL Financial. 

Sekera of Morningstar told MarketWatch that from a valuation standpoint, the technology sector has risen into an “overvalued territory” and these megacap technology stocks “have already run their course.”

According to Morningstar’s star-rating system in which a company with lesser star rating would be the most overvalued, while a company with a higher star rating would be the most undervalued, four of the “Magnificent Seven” cohort are rated 3 stars and two are rated 2 stars (see chart below). 

That cluster features Google parent Alphabet Inc.
GOOGL,
+0.50%,
 Apple Inc.
AAPL,
+2.31%,
 Meta Platforms
META,
+1.94%,
 Microsoft Corp.
MSFT,
+1.64%,
and Amazon.com
AMZN,
+1.92%
– as well as two new names, Nvidia Corp.
NVDA,
+3.63%
and Tesla Inc.
TSLA,
+1.66%.

Apple Inc.’s market capitalization closed above $3 trillion for the first time ever on Friday, as its shares rose 2.3% to end at $193.97 and passed the $190.73 price required to hit the milestone. The company became the first U.S. company to secure a $3 trillion valuation.

“According to our valuations, it appears this may be a good time to underweight this sector to add to overweight positions in communications and cyclical sectors,” said Sekera. 

“With the way the market has evolved over the first half of this year, now is a good time to be looking at your portfolio and making those reallocations out of those areas that are overextended… Now is a good time to take profit, especially since a lot of those stocks have run too far too fast in our view,” he said.

See: The Nasdaq-100 is headed for its best first half on record. But the rally faces a high-stakes test in July.

U.S. stocks finished higher on Friday with the Dow industrials up 285 points. The S&P 500 jumped 1.2%, while the Nasdaq Composite advanced 1.5%.