Stocks face their weakest seasonal stretch. Why extreme investor pessimism could limit any selling.

By Frances Yue

Based on a number of cycles - including one-year seasonal and four-year presidential cycles - the stock market tends to be weak from mid-August through early October

The S&P 500 hit a record closing high on Tuesday.

U.S. stocks are entering what has historically been their weakest stretch of the year, but unusually bearish investor sentiment could help limit any pullback, according to Ned Davis Research (NDR).

August through October has historically been the S&P 500's SPX weakest three-month span, according to a Tuesday note from the firm. NDR's cycle composite - which combines the one-year seasonal cycle, four-year presidential cycle and 10-year decennial cycle - points to weakness from mid-August through early October, as shown in the chart below.

The timing matters because investors are weighing whether to trim stock exposure after the S&P 500 rebounded from its recent pullback and climbed back to a record closing high on Tuesday. But although the seasonal calendar points to a tougher period for stocks, NDR said cautious investor sentiment, improving market breadth and stock-favoring asset-allocation models suggest there isn't enough evidence yet to turn bearish.

Seasonality is only one piece of the puzzle, according to the firm, and NDR is maintaining a modest overweight position in U.S. equities versus bonds and cash, strategists Ed Clissold and Thanh Nguyen said. NDR's asset-allocation model recommends a 70% allocation to stocks, 20% to bonds and 10% to cash, which compares with benchmark weights of 55%, 35% and 10%, respectively.

One reason NDR remained constructive was investor sentiment. The firm's short-term sentiment composite entered August in its "pessimism" zone before rebounding to neutral after Monday's rally, suggesting traders remain cautious even as stocks recovered.

The chart above illustrates just how cautious investors have become. NDR's daily trading sentiment composite entered August in its "extreme-pessimism" zone before rebounding to 44.44 on Monday, just inside neutral territory. Readings below 41.5 indicate extreme pessimism, while readings above 62.5 signal excessive optimism.

Sentiment is often viewed as a contrarian indicator, because if investors are overly bearish and already sold, their next action could be to buy.

And if a further rally pushes the indicator into its "optimism" zone, that reversal could create a more supportive backdrop than the seasonal weakness, the NDR strategists noted. Whether that happens by mid-August remains to be seen.

Another encouraging sign has been an improvement in market breadth, or the number of stocks and industries participating in the market's advance.

One of NDR's broader market-health gauges, the Fab Five Composite, which combines five of the firm's key market indicators, rebounded from bearish to neutral on Monday, reaching its highest level since late April, according to the strategists. The improvement was driven by its Tape Component, which measures how broadly the rally is being supported by tracking the percentage of U.S. industries and global stock markets in uptrends.

Basically, investors have continued rotating among different sectors and styles instead of exiting stocks altogether. While short-term participation has wavered, those rotations have kept NDR's longer-term breadth indicators from turning bearish, the strategists said.

NDR also highlighted one of the market's biggest reversals this year. Enthusiasm surrounding artificial intelligence had pushed growth stocks to more than two standard deviations above value stocks in late May. That trade has since unwound dramatically, leaving growth more than two standard deviations oversold relative to value, partly because of the recent blowup of the AI-focused hedge fund Situational Awareness.

Although NDR's longer-term growth-versus-value models now favor value by the widest margin in five years, the firm isn't recommending investors rush into the trade. Its tactical recommendation remains neutral.

"As growth works off its oversold condition, we will look for a better entry point into value," the strategists wrote.

-Frances Yue

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08-04-26 1725ET