- The stock market has rallied significantly since the middle of October.
- The number of new highs has decreased over the past two weeks.
- The S&P 500 is entering the high end of Doug Kass's expected trading range, near its 200-day moving average.
The major market indexes have rallied sharply since mid-October, hoping that slowing inflation will allow the Federal Reserve to stop raising interest rates. Since last month's lows, the S&P 500 and NASDAQ 100 have gained 12% and 11.2%, prompting optimism that the worst of a lousy year is behind us.
Optimism is understandable, but we’ve experienced similar disappointing advances this year, so it may be a good idea to view the rally with some skepticism. After all, it’s common to see double-digit rallies fail in bear markets, and while inflation data is encouraging, CPI has been falling since June, yet the market still stalled in August and made new lows in September and October.
A warning sign for stocks may be flashing
Stocks will likely find their footing as we get deeper into a bear market. However, a bell doesn’t ring on Wall Street, signaling that the midpoint of a bear market has passed and that it’s OK to abandon bear market playbooks.
Instead, we must weigh the evidence to determine whether stocks will continue higher or roll over. Unfortunately, evidence suggests the market could be running out of steam.
While stocks have risen nicely this month, fewer stocks are making new highs than a couple of weeks ago. That isn’t very encouraging because, in a strong tape, investors aren’t eager to sell stocks near new highs to lock in a profit. Instead, they stay long, allowing stocks to make even higher highs.
In “The New Highs Are Whispering to Us,” Top Stocks’ technical expert Helene Meisler digs into the data for insight. She writes:
“The number of stocks making new highs…have yet to surpass the reading from two weeks ago. The New York Stock Exchange had 65 new highs, with the peak reading two weeks ago at 98. Nasdaq had 111, with the peak reading two weeks ago at 140…The new highs tell us how emphatic the buying is. For now, it is tepid.”
Tepid isn’t necessarily bad, but the lack of new stocks hitting new highs is happening while investor sentiment is getting bullish, a concerning divergence. As Meisler points out, the put/call ratio, a sentiment measure of bearish put options trading relative to bullish call buying, flirted with its lowest reading of the year this week. Since that's a contrary indicator, it's not very bullish.
Furthermore, Meisler’s analysis of her intermediate-term overbought/oversold oscillator, which tracks advancing to declining stocks over the past 30 days, is likely to get overbought soon.
She writes, “I still expect the market to get to an intermediate-term overbought sometime near Thanksgiving, which is now just a week away.”
Meisler isn’t alone in wondering if stocks may soon lose some luster.
Real Money Pro’s Doug Kass correctly tilted bullish last month near the lows, but he’s grown more skeptical of the market now that it’s trading near the high end of his targeted range.
In his Real Money Pro trading diary, Kass wrote this week:
“The yield on the 2-Year U.S. note is flat to yield 4.363%. The 10-Year U.S. note yield is also unchanged to yield 3.797%. As I have written, above any other independent variables, the absolute level of rates keeps me at a relatively low net long exposure…
S&P cash closed on Tuesday at 3992 - and now stands near the upper end of my expected range (of 3700-4100) - resulting in an unattractive reward vs. risk compared to a week ago and relative to that range. At +100 S&P handles of potential upside and -200 S&P handles of potential risk, the odds of reward to risk was a negative -1:2.”
Kass’s expectation that the S&P 500 will be range bound until proven otherwise isn’t crazy, given that volatility could be high because of ongoing headwinds. For example, the War in Ukraine remains a threat, as we witnessed on Tuesday when a suspected errant missile struck inside Poland, prompting worry of escalation (see Kass’ diary entries on Tuesday).
Also, inflation remains at levels last seen in the 1980s, so consumers are still belt-tightening their budgets. Consumer spending drives about 70% of economic activity, and since many companies have recently discussed layoffs, there’s a real possibility corporate earnings will continue falling, pressuring stocks.
Those headwinds could make it challenging for the S&P 500 to capture the top end of Kass's range, a level that roughly intersects with resistance at the index's 200-day moving average.
The Smart Play
Unfortunately, the duration of a bear market is determined in retrospect with hindsight. Investors can look for clues from past bear markets, but those signals aren’t infallible.
For instance, it’s historically a good sign when the stock market retraces 50% of losses in a bear market. Since World War II, it’s unlikely for stocks to make new lows when that happens. Nevertheless, we still undercut June’s low in October despite eclipsing the 50% threshold in August. This signal similarly preceded weakness in 1974, 2004, and 2009, so it’s imperfect.
Furthermore, the traditional start of a bull market is characterized by a 20% rise in the index from its low point. Although we got close (~19%) in August, we’ve yet to eclipse that hurdle this year. Again, this isn’t a perfect indicator. Recall we had multiple 20% plus rallies after the internet bust that only proved to be bear market rallies.
Many are also expressing confidence in the rally because of strong seasonality. For instance, November marks the beginning of the seasonally-strongest six-month stretch of the year for stocks, according to Stock Trader's Almanac. Yet you still have periods where this tailwind doesn't pan out because of an uncooperative economy or market, including 2007, 2008, and 2019. Remember, the Fed was hiking rates and embracing quantitative tightening (not replacing maturing bonds on its balance sheet) in 2018, and stocks' fourth-quarter performance was terrible despite seasonal probabilities.
One potential signal stocks could continue climbing is when 90% of stocks trade above their 50-day moving average. That happened in 2003, 2009, and 2020 shortly after the lows. Unfortunately, we’ve yet to reach that level this year, so that indicator is off the table for now.
Overall, it’s hard to know precisely when a bear market is over, so it’s best to exercise caution and play defense. After all, the market has made a big move, and now it needs to prove itself.
Given the relative lack of new highs, a potential overbought reading on Meisler’s intermediate-term oscillator, and the S&P trading near the upper band of Kass’ range, investors might want to play some defense. For instance, it could be a good time to move stop losses up, put some profit in pockets, and use strength to sell stocks where the thesis is broken.