Can This Market Rally Continue?

 

The U.S. stock market has rallied sharply off its late October lows, bringing us to fresh highs in several large cap indexes.  On Thursday we saw particular breadth strength with over 2500 stocks across the major indexes registering fresh monthly highs and over 1700 making new three-month highs.  At the same time, only 188 and 86 stocks hit new one- and three-month lows.  Thanks to the dovish shift by the Federal Reserve and a dramatic turn lower in interest rates, the buying was broad, lifting both small and large cap shares.  When we see large moves across asset classes--fixed income, currencies, equities--we know that something fundamental is afoot among macro investors.  But what comes next?  After such broad strength, do we see further upside momentum or reversal?  Let's take a look at recent market history.

As I have indicated in the past, strength (as measured by the number of shares making fresh new highs) and weakness (as measured by new lows) need to be considered as relatively independent variables.  To be sure, the two are related--since 2016 (almost 2000 market days), the correlation between 1 month new highs and lows is -.54 and between 3 month new highs and lows is -.46.  What this means is that only about 25% of the variance in new lows is accounted for by the number of new highs and vice versa.  (All data from Barchart.com).

When we examine the historical data since 2016, we can see the importance of considering strength and weakness separately.  For instance, we've only had 24 days in that time where three-month new highs exceeded 1000.  Over the next 10 trading sessions, SPY averaged a loss of -.11%, compared with  +.23% for the remainder of the sample.  Over the next 50 trading sessions, however, SPY gained an average of +3.81%, well more than the average gain of +2.39% for the remainder of the sample.  Indeed, when we have had an explosion of new highs, the market was up 21 times, down only 3 over the next 50 days.  Over the next 10 days, it was up 11 times, down 13.

Conversely, when three-month new lows are below 100 (N = 475), returns have been superior over the next 20 trading sessions, averaging a gain of +1.99% vs. an average gain of +.59% for the remainder of the sample.  In other words, when new highs are high, we have seen momentum over a longer time horizon; when new lows have been low, we see shorter-term upside momentum.  When new highs are high *and* new lows are low, the pattern has been similar to that for elevated new highs:  weak returns over the next ten trading sessions; superior returns over a 50-day horizon.

No doubt, forward news on inflation and growth will impact rates markets and that, in turn, could move stocks.  During rising trending/momentum markets, I have found it to be helpful to look for short-term oversold points in the market (points during which the majority of stocks close below their 3 and/or 5 day moving averages) that occur at higher price lows.  Those dips are opportunities to participate in the broader trend and also create logical spots to stop out if the uptrend is broken.  At least for now, markets are treating the Fed news as a game changer.  Recent historical evidence suggests that the rising tide lifting all boats often continues, though not necessarily in the short run.

Further Reading:

Using Emotion to Change Emotion

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