Looking Ahead After Wall Street’s Best Quarter Since 2020
The S&P 500 gained 15% and the Nasdaq 21% in Q2, but Q3 presents substantial challenges as three big issues come into play.
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Wall Street just closed one of its best quarters in years but there is some increased caution as investors look ahead to the third quarter. Futures are mildly negative early on the first day of July, but historically, this is one of the strongest days of the year on a seasonal basis due to 401(k) and retirement inflows.
The second-quarter numbers were impressive. The S&P 500 gained 15% and the Nasdaq Composite added 21%, marking the best quarter for both since 2020. The Dow Jones Industrial Average rose 13% for its best quarter since 2022. The S&P has notched 24 record closes this year, the Nasdaq 20, and the Dow logged its 19th record on Tuesday.
The action was concentrated where you would expect. Micron Technology (MU) surged 242% in the quarter. Advanced Micro Devices (AMD) soared 186%. Broadcom (AVGO) gained 22%. Nvidia (NVDA) was up 15%. The PHLX Semiconductor Index climbed 88% for its best quarter on record. The chip suppliers that provide the memory and processors for AI infrastructure captured the bulk of the value generated by the AI trade.
The Rotation Under the Surface
From a trading standpoint, the more interesting development is what happened outside the semiconductor group. The Roundhill Magnificent Seven ETF (MAGS) lagged badly through much of June, even while the indexes were hitting new highs. The rotation into other sectors has been gaining traction for weeks.
The Russell 2000 and the Dow Jones Transportation Average both produced their best start to a year since 1991. In June the Dow outperformed the Nasdaq and S&P 500 by the widest margin since October 2022. Financials gained 4.2% in June, healthcare increased 6.5%, and industrials climbed 7.2%. Communication services and information technology both dropped more than 3% in the same month.
That is the rotation I have been writing about for weeks and it is likely that it is going to continue. Chips are extended and need a rest and there is a growing consensus that technology may not be the dominant theme despite the endless AI hype.
Three Issues for the Third Quarter
Three big issues will drive the market through the third quarter. The first is AI capex and margins. Micron demonstrated last week that the chip suppliers have monopoly pricing power for now, with gross margins of 84.9% in the most recent quarter versus 39% a year ago. That is great news for Micron but not so hot for the hyperscalers that have to pay those prices. This not only hurts big AI players but it is inflationary and that causes an additional set of problems.
Hyperscaler capex is estimated at $741 billion this year, up nearly 75% from last year. That level of spending raises the question whether buyers can maintain strong margins while spending what they need to spend. Will there be some pressure on Micron and others as Apple (AAPL) looks for alternative chip supplies and Korea aggressively expands capacity?
The second issue is the potential for higher rates. Fed Chair Kevin Warsh surprised the market at his first meeting by signaling more concern about inflation than expected. Nine of 18 officials now see at least one hike this year.
The market is pricing a 70.4% probability of a Fed rate hike before the election, up from around 40% three weeks ago. The May Personal Consumption Expenditures data last Thursday came in at 4.1%, which is more than double the Fed’s 2% target. The June jobs report Thursday morning is the next key data point and will influence the view of inflation.
The third issue is the normalization of Iran and oil. The Iran situation is being managed through repeated pause-and-restart cycles which is no longer having much market impact.
Brent crude was down 38% in Q2 for the worst quarterly performance since Covid. If it continues to hold, the disinflationary impact of lower energy prices helps offset some of the AI-driven inflation. If oil moves back higher it will complicate matters for the Fed especially if the economy stays strong.
The Seasonal Setup for the Next Few Days
The next two days in front of the July 4 holiday have a strong seasonal tendency. In addition, July has finished higher than it opened 80% to 85% of the time on the S&P 500 and Nasdaq 100 over the past 20 years, with average gains above 2.5%. The past 10 years show even stronger numbers.
Strategy
Keep in mind that seasonality is a tendency and not a certainty. There are a lot of folks aware of the seasonal pressures and it wouldn’t be too surprising for some contrarian action to surprise complacent bulls.
There is no immediate positive catalyst on the horizon between now and the start of earnings season. Earnings are expected to be robust with Q2 profits forecast to grow 22% and full-year 2026 growth expected at 23%. Eighty-five percent of S&P 500 companies beat Q1 expectations, the highest percentage since 2021. The earnings backdrop is strong, but valuation arguments will persist and the pace of gains has to slow.
Technically the market needs some rest and consolidation. The chip names cannot go up another 200% in the third quarter and the Mag 7 unwind may not be over. The rotation into biotech, industrials, financials, and small-caps is likely to continue but the specific names within those groups need to be picked carefully. It would not take much to trigger a pullback. A hot jobs number Thursday, a hawkish Fed speaker, a break in the Iran ceasefire, any of them could produce a convenient excuse.
My game plan stays where it has been, with high cash levels and a focus on the rotation winners and names with their own catalysts. I’m not chasing the chip rally or the Mag 7 bounce.
The seasonal tailwinds should support the next several sessions but I am not being aggressive because the risk of a pullback grows the further we get from the calendar support. Don’t be too anxious to fade the strength while the calendar is working, but do not confuse the seasonal tailwind with sustainable market health either.
The third quarter is going to be an interesting one as there are some transitional themes developing. My best advice is to not try to predict how things unfold but stay highly reactive and be aggressive when a shift starts to take hold.
At the time of publication, Rev Shark had no positions in any securities mentioned.
