Here's why the stock market could be primed for a year-end rally

• The stock market has slumped in August and September, but Ned Davis Research says there is reason for optimism.
• Sentiment is nearing "extremely pessimistic levels," which could support a year-end rally.

After a strong start to 2023, stocks have slumped over the last two months — but that doesn't mean the home stretch of the year can't see strong gains.

As of Wednesday's close, the S&P 500 has shed 5% in September, while the Dow Jones Industrial and the Nasdaq have tumbled 3% and 6%, respectively.

In a Wednesday note, strategists from Ned Davis Research pointed out that because the recent pullback has come at a seasonally weak time of year, there's still potential for upside in the last quarter of 2023.

"[S]entiment is approaching extremely pessimistic levels, suggesting that a year-end rally is not off the table," NDR said.

The NDR Crowd Sentiment Poll recently reversed from its excessive optimism zone to hit its lowest mark since June. While the "extreme pessimism zone" hasn't been reached yet, the strategists pointed out that the strongest returns for the S&P 500 have come after that trough is hit.

The shorter-term NDR Trading Sentiment Composite, too, dropped into its pessimism zone last week, suggesting that traders are currently cautious.

"We would note that more consistent returns have come from more pessimistic levels," NDR said. "After the Daily Trading Sentiment Composite has fallen below 20, the S&P 500 has traded higher one month later 90% of the time."

To be sure, the strategists said investors may also be caving to the Fed's higher-for-longer messaging, which could imply the seasonal slump extends longer than usual. Certain negative technical signals have led the firm to remain cautious, and the risks surrounding tight monetary policy are still looming.

The spike in bond yields, for example, chips away at the bullish argument for stocks, and equities are now expensive relative to long-term bonds, the firm said.

"The S&P 500 earnings yield has fallen below the 10-year Treasury yield for the first time since 2009," the strategists wrote, adding that on balance, it's becoming more difficult to describe stocks as cheap compared to bonds.

In any case, the pessimistic data comes as the NDR S&P 500 Cycle Composite is about to finish its weak seasonal stretch.

And from both a technical and sentiment standpoint, the "recent weakness could be setting the stage for a year-end rally."