Is a Rising Market Due for a Fall--Or Not At All?

Many traders have been bemused by the equity markets' recent strength. There have been regular observations of an "overbought" market, only to see that market become still more "overbought". When is a rising market part of an ongoing trend, and when is it about to end?

One rough guideline that I track in the Trading Psychology Weblog is the proportion of S&P 500 stocks trading above their 50-day moving averages. This proportion tends to peak ahead of price peaks--and in recent years, it has had to reach at least 80% to make a peak. Throughout the recent market rise, that proportion has been growing. It now stands at about 84%.

A more direct way to measure market momentum is to examine the size of price moves and what typically occurs after large vs. moderate rises. Going back to 1990 (N = 4173 trading days), we've had 475 occasions in which the S&P 500 Index ($SPX) has made a 60-day price high. Sixty days after that, the market has risen by an average of 2.26% (325 up, 150 down). That is no different from the average 60-day price change of 2.19% (2835 up, 1338 down) for the sample overall. In other words, just because a market has made a 60-day high doesn't mean it's overextended. Its prospects are no different from average.

But wait. Let's divide our sample of 60-day highs in half based on the number of stocks making 52-week new highs at the end of the rise. When the 60-day high occurs with a relatively strong market participation of over 180 new highs (N = 238), the next sixty days in $SPX average a gain of 3.26% (187 up, 48 down)--a nice outperformance. When the 60-day high occurs with a relatively weak participation of under 180 new highs (N = 237), the next sixty days in $SPX average a gain of only 1.26% (138 up, 99 down)--a notable underperformance. This fits other findings from my research, including the findings regarding the proportion of stocks above their moving averages: The broader the market momentum during a rise, the more likely it is to persist in the following time frame.

Some rising tides lift all boats; others do not. That's one way we can handicap the odds of the tides coming in--or rising yet further. Having made a 60-day high on Thursday with over 300 new highs, it is difficult to make a case based on recent historical precedent that the market has become more vulnerable to decline.

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