In recent weeks, financial markets have demonstrated notable strength across multiple dimensions, characterized by a rare multi-day breadth thrust, a significant shift in investor sentiment, and a sharp multi-day correction.
We examine these themes in detail below with an emphasis on historical data and a philosophy geared toward placing recent events in a larger timeframe context.
Multi-Day Breadth Thrust: In the past week, markets logged a rare multi-day breadth thrust (before selling began mid-week), a technical phenomenon indicating broad market participation in the rally. This event is marked by a significant number of advancing issues relative to declining ones, suggesting robust underlying market strength. Notably, the Nasdaq 100 has delivered a rare and bullish signal, reflecting widespread investor confidence in large-cap technology stocks.
Massively Overbought: However, the recent rally has propelled the S&P 500 into overbought territory across five timeframes simultaneously. While this indicates strong upward momentum, it also raises cautionary flags about potential near-term corrections. Investors should remain vigilant for signs of profit-taking or market consolidation, which could provide more favorable entry points.
Rotation into Small-caps: Over the past week, there has been a historical shift from large-cap to small-cap stocks. This rotation reflects a growing investor preference for smaller, potentially undervalued companies. More than half of small-cap stocks have reached new highs, underscoring the breadth and strength of this movement. This trend suggests a heightening of risk-on sentiment among investors, who are seeking higher returns in a recovering market environment.
Breadth Thrust Signals Bullish Trend
The New York Stock Exchange (NYSE) has recently experienced a notable increase in its advance-decline ratio as of mid-week, indicating a breadth thrust that historically precedes strong returns for the S&P 500. While this has been cancelled to some extent over the past two sessions, the signal still occurred and should be taken as real.
As of Wednesday, July 17, 2024, for only the 26th time since 1936, advancing issues on the NYSE have outpaced declining issues by a ratio of 3 to 1 over successive trading sessions, with the S&P 500 hovering within 1% of a five-year high. This phenomenon has significant implications for investors, suggesting a bullish outlook for the market over the next six months.
Historical data shows that following similar breadth thrusts, the S&P 500 has displayed outstanding returns and consistency. Since 1951, several periods have demonstrated a perfect 100% win rate for the S&P 500 over the subsequent six months after such breadth increases. This consistent performance underscores the predictive power of breadth thrusts in signaling strong market momentum.
The recent breadth boost aligns with this historical trend, indicating that the market may be poised for further gains. The equal-weighted S&P 500, which gives each stock an equal impact on the index, has outperformed the cap-weighted version, where larger companies have more influence, 82% of the time following similar breadth thrusts. This suggests that smaller and mid-sized companies are likely to contribute significantly to the market's performance in the coming months.
On July 5th, the percentage of S&P 500 stocks outperforming the S&P 500 Index over a rolling 21-day period fell to its lowest in history. Historically, whenever this indicator drops below 30%, the equal-weighted S&P 500 index has generated an annualized return of 23%, exceeding the cap-weighted return of 21%. This further supports the argument for a robust market outlook, particularly for a diverse range of stocks.
The equal-weighted S&P 500's historical outperformance in such scenarios suggests that market gains will not be confined to the largest companies but will be broadly distributed across the index. This breadth of performance can provide a more stable and resilient market environment, reducing the risk of overreliance on a few large-cap stocks.
For investors, the recent breadth thrust presents a compelling case for maintaining or increasing exposure to the S&P 500, particularly through equal-weighted index funds or ETFs. The historical data indicates that such periods of strong breadth are often followed by substantial market gains, providing an attractive risk-reward profile.
Moreover, the outperformance of the equal-weighted index suggests that diversifying investments across a broader range of companies, rather than concentrating on the largest firms, could enhance returns. Investors may also consider reallocating funds from cap-weighted to equal-weighted strategies to capitalize on the anticipated broad-based market strength.
The recent breadth thrust in the NYSE advance-decline ratio signals a bullish outlook for the S&P 500 over the next six months. Historical performance following similar events suggests strong and consistent returns, with the equal-weighted S&P 500 often outperforming its cap-weighted counterpart.
The Nasdaq 100 Index also saw a significant upward move before experiencing a brief but sharp decline later in the week. Despite this volatility, the Nasdaq Zweig Breadth Thrust indicator has flashed a bullish signal. This indicator, which calculates a 10-day exponential moving average of advancing issues as a percentage of total issues, suggests strong bullish momentum. Historically, such signals have been followed by higher prices, reinforcing the positive outlook.
The critical aspect of this indicator is its high win rates across all time frames, particularly for periods of two months and beyond.
Overbought Conditions in the S&P 1500
Another noteworthy development is the surge in the percentage of S&P 1500 stocks entering overbought territory last week. While high readings are often viewed negatively, signaling potential market corrections, historical data suggests otherwise.
In the long run, such overbought conditions have frequently highlighted periods of market thrust, ultimately driving the stock market higher. These high readings indicate robust market participation and investor confidence, suggesting that the current momentum could sustain further upward movements.
For investors, these indicators provide compelling evidence to maintain a bullish stance. The Nasdaq Zweig Breadth Thrust and the overbought conditions in the S&P 1500 both point towards a favorable market environment.
Moreover, the historical success of these indicators adds credibility to the bullish case. With win rates exceeding 80% for all time frames beyond two months, the odds are strongly in favor of continued market growth.
The recent signals from reliable market indicators suggest a positive outlook for the stock market in the year ahead. The Nasdaq Zweig Breadth Thrust's bullish signal and the high percentage of overbought stocks in the S&P 1500 both point to sustained market momentum. Investors should take note of these indicators and consider maintaining or increasing their market exposure to benefit from the anticipated upward movements.
By leveraging these insights, investors can position themselves strategically to navigate the market effectively and maximize their returns. As always, staying informed and monitoring these key indicators will be crucial in making well-informed investment decisions.
Broadening Trend or Blow-off?
Recent market activity has resolved many of the breadth-related divergences that have been concerning for the past two months. But sentiment and technical data suggest this could be either a broadening of the larger bullish trend, or the wipe-out of the remaining hide-outs for bears and shorts in the market. In the former case, it is a bullish signal. In the latter, it's a setup for an important top.
A historic couple of days last week saw a significant rush into smaller-cap stocks, which had a monumental impact on various breadth measures. This surge was sufficient to push the NYSE Cumulative A/D Line to a record high.
The A/D Line, which tracks the number of advancing versus declining stocks, is a key indicator of market breadth and overall market health.
Interestingly, the S&P 500 had been leading the A/D Line for over a month, setting more than a dozen new highs in the past 30 days while the A/D Line diverged.
Historically, when the S&P 500 outpaces the A/D Line to a significant degree, its forward returns tend to be less compelling. However, it's important to note that this observation is based on a very small sample size, so conclusions should be drawn cautiously.
The version of the A/D Line that includes only common stocks (excluding preferred shares and other issues) has not yet made a new high. This divergence is noteworthy because it suggests that while the overall breadth of the market has improved, the performance of common stocks alone has not reached the same level of strength.
Historical data shows that when the main A/D Line sets a fresh 52-week high for the first time in at least 30 days, but the stock-only version is at least 1% off its own high, the market tends to show relatively weak returns up to a month later.
However, over the following 3-12 months, returns have historically been strong. This pattern suggests that while short-term caution may be warranted, the longer-term outlook remains positive.
The resolution of divergences and the new high in the NYSE Cumulative A/D Line are positive signals for the market. The strong performance of smaller-cap stocks and the improved breadth measures indicate a healthy and broad-based rally.
However, the divergence between the main A/D Line and the stock-only version suggests that investors should remain vigilant in the short term.
For longer-term investors, the historical performance data provides a compelling case for maintaining a bullish stance. The market's strong returns over the 3-12 months following similar divergences in the past indicate that the current environment could offer attractive investment opportunities.
Market Analysis: S&P 500 Overbought Across All Time Frames
The stock market has experienced an impressive rally, spanning days, weeks, months, quarters, and even years. This sustained upward momentum has pushed the S&P 500 into overbought territory across all these time frames, a phenomenon not seen in three years.
The 14-period Relative Strength Index (RSI) for the S&P 500 is now above 70 on daily, weekly, monthly, quarterly, and yearly charts, signaling a significant level of bullish momentum.
The RSI is a momentum oscillator that measures the speed and change of price movements, with values above 70 typically indicating overbought conditions.
The current situation, where the minimum RSI value across all five timeframes exceeds 70, underscores the powerful and sustained nature of the market's recent performance.
However, historical data suggests caution. When the minimum RSI has been 70 or greater, the S&P 500's annualized return was -4.1%, significantly lower than returns during non-extreme periods.
This implies that while the market is experiencing strong momentum, the risk/reward ratio over the next few months may be unfavorable.
Historical Performance and Sector Analysis: Despite the poor risk/reward ratio, historical patterns indicate that significant declines are rare following such momentum-based extremes. Over the next three months, past instances have shown no declines larger than -10%, but also no gains larger than +10%. This reflects a period of consolidation where the market may experience limited volatility and range-bound movements.
The win rates for different sectors vary significantly in these conditions. Historically, the staples sector has gained 91% of the time three months after the minimum RSI exceeded 70, compared to only 45% for discretionary stocks. This suggests that investors might find more stability and potential gains in defensive sectors like consumer staples during periods of extreme overbought conditions.
For investors, the current overbought condition across all time frames presents both opportunities and risks. On the one hand, the strong momentum suggests that the market is in a robust uptrend, which could continue in the short term. On the other hand, the historical underperformance following similar conditions advises caution.
Strategies in play:
Sector Rotation: Shifting investments towards sectors with higher win rates, such as consumer staples, can provide more stability and potential gains during overbought conditions.
Risk Management: Implementing stop-loss orders and reducing exposure to high-volatility stocks can help manage risk in anticipation of potential consolidation.
Diversification: Maintaining a diversified portfolio can mitigate the impact of sector-specific volatility and provide a buffer against market fluctuations.
Short-Term Caution: Be prepared for potential short-term underperformance in the financial sector. This could provide a buying opportunity as the sector often rebounds and outperforms over the medium to long term.
Diversification: Maintain a diversified portfolio to mitigate the impact of any short-term volatility in the financial sector. Diversification can help balance the portfolio and reduce risk.
Monitoring Key Indicators: Keep an eye on broader market indicators and economic data that could impact the financial sector. Changes in interest rates, credit conditions, and regulatory developments can influence sector performance.
Long-Term Investment: Consider increasing exposure to the financial sector as part of a long-term investment strategy. Historical data suggests that the sector tends to perform well following periods of significant strength.
The S&P 500's (SPY) current overbought status across all major time frames highlights an exceptional period of market momentum. While historical data suggests a cautious outlook with limited near-term returns, significant declines are also rare.
Investors should balance the opportunity for continued gains with prudent risk management strategies, focusing on sectors with historically higher resilience and maintaining a diversified approach to navigate potential market consolidations effectively.
Rotation into Small-cap Stocks
A recent benign inflation reading has drastically altered investors' outlooks, leading to a significant shift in market dynamics.
Over the span of five days, the ratio of small-cap total return to large-cap total return jumped by nearly 10%. This shift is one of the largest seen in nearly a century, especially notable given the volatility of such ratios during the 1930s. Starting from 1950, we see that shifts of at least 7.5% toward small caps over a week are rare and historically significant.
While the ratio experienced some volatility in the weeks following this dramatic shift, historical instances of such large movements have typically led to a renewed investor preference for smaller stocks for several months. However, with a small sample size of three, confidence in the predictability of this trend is limited.
Historical analysis: According to research from Sundial Capital, when the small-cap-to-large-cap ratio fell to a multi-year low followed by a 5-day shift of at least 4% while marking the largest shift in at least a year, most historical occurrences resulted in fake-outs, where the initial enthusiasm for small caps was not sustained over the following weeks and months.
The Federal Reserve is a key player in this story as well as easing cycles have historically benefited smaller stocks over larger ones. Peaks in the Fed Funds Rate often coincide with crucial bottoms in the small-cap to large-cap ratio. As investors anticipate the next easing cycle (which has been indicated by a recent drop in inflation data), they have often initiated this dramatic shift toward small caps.
We initiated a long position recommendation in the IWM on this basis in November 2023 at around $182/share, as indicated in our past articles.
While the magnitude of this recent adjustment has few precedents, historical data suggests a good chance that this trend could last for several months at least.
In short, the recent seismic shift from large-cap to small-cap stocks is a significant development in the current market environment. While historical data provides some insights, the unprecedented nature of the recent move suggests that investors should approach this trend with both optimism and caution.
A Bullish Signal for the Market?
The recent accelerating surge in the percentage of Russell 2000 stocks hitting a 21-day high suggests a favorable outlook for the small-cap index over the next year. On Monday, more than 50% of Russell 2000 (IWM) stocks reached this milestone, a rare event that has occurred only 24 times since 1979.
The last time this happened was in December 2023, which led to notable gains over the following three months.
When the percentage of Russell 2000 stocks registering a 21-day high exceeds 50%, the small-cap index has historically shown solid returns and consistency. Following such instances, the Russell 2000 rose 82% of the time over the subsequent year. This historical trend suggests that the recent surge in new highs could signal a period of strong performance for small-cap stocks.
Moreover, the S&P 500 also tends to perform well following these signals. Over the subsequent year, the S&P 500 was higher 95% of the time, with the only loss occurring during the 1987 crash. This indicates that the bullish sentiment extends beyond small-cap stocks, suggesting a broader positive market environment.
In cases where the percentage of Russell 2000 stocks hitting a 21-day high coincided with a 2-year high in the index, both the Russell 2000 and the S&P 500 displayed a 100% win-rate from two weeks to twelve months later. The Russell 2000 outperformed during these periods, highlighting the potential for significant gains in small-cap stocks.
New highs across all time frames were most prevalent in the Financials and Real Estate sectors within the Russell 2000. Banks comprise a significant proportion of the constituents in the Russell 2000 Financials sector, which has shown strong performance recently. The robust performance of these sectors contributes to the overall bullish outlook for the small-cap index.
New Highs in Financial Sector Stocks
The financial sector has recently shown significant strength, with more than 45% of S&P 500 Financial sector stocks registering a 52-week high. This surge is particularly noteworthy as it coincides with the sector closing at a 5-year high. Historically, such surges have preceded a bullish outlook for Financials, which often bodes well for the broader market.
Financials are a systemically important sector, often providing early warnings of significant market peaks. The recent increase in 52-week highs within the sector suggests that the stock market is less likely to be on the brink of a credit-driven risk-off period. Historically, when more than 45% of financial sector stocks hit a 52-week high while the sector is at a 5-year high, the S&P 500 Financials have displayed solid returns and consistency over the medium to long term.
This trend indicates that the financial sector's current strength is a positive sign for the broader market. The S&P 500 has historically risen 85% of the time in the year following similar surges in the financial sector, underscoring the sector's importance in driving market performance.
While the long-term outlook is positive, historical data shows that the financial sector can struggle in the short-term following such surges. In the month following a surge, the S&P 500 Financials have tended to underperform the S&P 500. Since 1981, this underperformance has occurred in 13 out of 15 instances.
However, this short-term struggle is typically followed by outperformance from two to six months later. This pattern suggests that while there may be some initial volatility and underperformance, the financial sector tends to regain strength and contribute positively to the broader market over time.
The current surge in financial sector stocks hitting 52-week highs presents both opportunities and challenges for investors. Given the historical trends, investors should consider the following strategies:
Overall, the recent surge in 52-week highs among S&P 500 Financial sector (XLF) stocks signals a bullish outlook for the sector and the broader market. While short-term performance may be volatile, the long-term prospects remain strong. Investors should consider maintaining a diversified portfolio and be prepared to capitalize on potential buying opportunities in the financial sector.
Conclusion
While the market has been clearly overbought, it remains in a larger-timeframe upward trend. And, as every experienced market participant comes to learn—often the hard way—there's no such thing as overbought in an uptrend or oversold in a downtrend.
As Keynes put it, markets can stay irrational longer than you can stay solvent.
We have been on the lookout for a summer correction and consolidation period. This may be upon us now. But the weight of evidence suggests the recent expansion in breadth to fuel small-caps and financials and vault the cumulative advance-decline measure to new all-time highs is likely to be grist to the mill for those committed to taking advantage of near-term weakness as a ticket to board the next leg of a continuing bull market.