Two Important Takeaways From The Recent Stock Market Action

 

Update:  7/14/24 - We continued to see breadth strength on Friday and finished the session with 1901 stocks across the NYSE making fresh monthly highs and only 109 registering new monthly lows.  This is considerable breadth strength, bolstered by buying of small- and midcap shares.  Interestingly, going back to 2010 (over 3400 trading sessions), we've only seen 45 trading sessions in which we had over 1500 new monthly highs and less than 150 fresh monthly lows.  Three days later, the SPX averaged a loss of -.41% (17 up, 28 down), quite a difference from the average three day gain of +.35% for the remainder of the sample.  Once we look 20+ days out, there was no downside bias.  I will be watching for near term weakness following the recent strength, mindful of the bigger picture bullish implications of the breadth thrust (see below).  I'll especially focus on which sectors are relatively strong and weak during any market pullback; that information could help set up a good trade.  

On Thursday, the stock market was quite the magician.  Good magicians will get you to look at what they're doing with their right hands but meanwhile the actual "magic" is happening outside our awareness, in the left hand.  The market's right hand gave us a solid decline in the SPX and especially in the growth areas that have been unusually strong.  The left hand, however, pulled off the real magic.  Market breadth increased significantly, creating what we call a breadth thrust.

The purpose of most of my quantitative analyses is to investigate market history and see if a given move is likely to lead to retracement (mean reversion) or momentum (trend).  If I can get a clear signal from market history, I then look at high frequency data to identify solid risk/reward points for entry in the direction of the analysis.  From this perspective, the "setup" is not the trade idea; edge occurs when the market sets up in the direction of solid research.

The market magic yesterday is that we saw very strong smaller cap stocks at the same time that SPX and tech sold off.  Up to now, small and midcap stocks have largely underperformed the large cap and especially the tech market.  Not yesterday.  According to the excellent Barchart resource, that created a situation in which 1518 stocks across the NYSE made fresh monthly highs and 187 registered new monthly lows.  Moreover, if we take a look at the number of stocks giving buy vs. sell signals on technical indicators on the very helpful Stock Charts site, we find that yesterday registered over 600 stocks giving buy signals on their Bollinger Bands and only 13 gave sell signals.  That is unusual breadth strength.

I've tracked these readings since 2019 and can tell you that, in over 1200 trading sessions, we've only seen that kind of breadth strength six times.  Moreover, when we've seen 400+ stocks close above their upper Bollinger Bands on the same day (N = 25), the SPX has been up 21 times, down 4 over the next ten trading sessions.  Interestingly, there has been no distinct upside edge up to 5 days out.  Where that leaves me is looking for short term pullbacks in the broad market that cannot make new lows in order to participate in anticipated continued strength.  It also has me looking with fresh eyes at the specific sectors likely to show this momentum.

So what's the second takeaway from yesterday's market action?  It's that the entire move was triggered by a drop in interest rates in the U.S.  Moderation of inflation numbers led to a rally across the curve.  Not so long ago, I was getting close to 5% on my two-year T-notes.  Now we're closer to 4.5%.  The markets are suggesting that economic strength will broaden out if we indeed see a sustained move toward lower rates from the Fed.  That is important information for traders and investors alike.  What were the best trades in a higher rate regime may not be the best trades if rates sustain a fall.

There are many implications for trading psychology in all this...I'll outline those in the next post.  

Further Reading:

Using Breadth, Strength, and Momentum to Track Market Cycles

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