TradingEdge for Nov 12 - Sentiment surge, breadth recoveries, commodity concerns
Key points:
- Options speculation now rivals the February peak
- Momentum has been good, with small-caps and Nasdaq stocks recovering
- Major sentiment models are showing short-term overheated conditions
- Consumer Discretionary stocks have enjoyed a breadth thrust
- Economic reports have been beating economists' expectations
- Energy contracts face headwinds, and the surge in gold miners is suspect
Option speculation nears record
Among all traders on all U.S. exchanges, net speculative volume is equal to the peak during the week ending February 12. There's no point showing the complete history as we did last week because extremes over the past year are so far beyond anything seen in the prior 20 years that it completely distorts a chart.
The only true comparison to the type of speculative options behavior last week is the week ending February 12. After that blow-off, each of the "big four" indexes suffered declines lasting about 3 weeks. The Dow suffered the least; the Nasdaq lost the most.
When looking at some of the most popular funds, and the sector SPDRs, the clear pattern is that some of the most speculative areas of the market took the biggest hits and took the longest to recover.
Small-caps start to outperform
A trading model that measures when small-cap stocks reverse from underperforming to outperforming relative to large-cap stocks issued a buy signal at the close of trading on Monday, according to Dean's analysis.
The small-cap range rank signal triggers when the 4-month range rank for the ratio between small and large stocks reverses from less than 1% to greater than 98.75%. Typically, when small-cap stocks surge relative to large-cap stocks, economic growth accelerates, and stocks perform well.
This signal has triggered 42 other times over the past 43 years. After the others, future returns in the S&P 500 were solid across all time frames, with several solid risk/reward profiles. Most of the unfavorable signals occurred during bear markets, which is not the case now.
When small-cap stocks surge, it suggests the economy is undergoing a resurgence in growth that provides a tailwind for the stock market. Similar setups to what we're seeing now have preceded rising prices for S&P 500 over the medium-term.
Nasdaq finally shows some positive underlying momentum
For the first time in months, the momentum in securities traded on the Nasdaq exchange has turned positive. After a furious rally to start the year, so many stocks were churning that breadth on the Nasdaq couldn't surpass its highs at the start of the year. By mid-summer, it turned outright negative and stayed there until last week.
What's especially notable about the current flip to positive momentum is that it triggered as the Nasdaq Composite was on a run to new highs. Since 1986, there have been 8 similar signals.
If we expand the sample size by including times when the Nasdaq was at least out of correction territory, results were similar.
When the McClellan Summation Index for any sector or index is in positive territory and rising, it tends to be the best possible scenario for future returns. That's where the Nasdaq is sitting now. While short-term returns can be poor, or inconsistent at best, long-term returns have been very positive after the Summation Index turns positive following months in negative territory.
And fewer of them are in corrections
Dean showed that the percentage of Nasdaq 100 (NDX) members in a correction has dropped sharply from just a few weeks ago. We use the widely accepted definition of "correction" as being down 10% or more from a 52-week high.
A similar signal has triggered 10 other times over the past 19 years. After the others, future returns and win rates were solid across all time frames, especially on a medium- to long-term basis.
Sentiment has become extremely optimistic
The lack of optimism in September didn't last long, and now it's back to an extreme.
If we combine four major sentiment models into one, we can see how a broad cross-section of sentiment-related measures compares versus other periods. And there are almost no precedents.
Clearly, such high optimism had no long-term impact on the prospects for stocks when it triggered in February.
Even so, the chart shows us that the S&P 500's annualized return when the composite model was above 80% was a miserly -9.2%. When the model was above 85%, accounting for about 2% of all days since 1998, that return was a horrid -15.6%.
This has been among the least effective years ever in terms of sentiment analysis, with extremes from January and February having limited impact on the S&P though higher-risk areas saw bigger and longer-lasting declines.
Consumer Discretionary stocks enjoy a breadth thrust
Dean showed that momentum in the Consumer Discretionary sector continues as the group once again had the best relative trend score improvement versus last week. The sector registered a new relative high on 4 out of 5 days.
Participation from constituents in the S&P 500 Consumer Discretionary sector is solid. A breadth composite using a handful of measures just crossed above 56%, after having reset below 5%. The same signal triggered in June 2020, leading to a substantial rally.
This has triggered 46 other times since 1954. After the others, future returns and consistency in the sector were excellent across all time frames, but especially over the next 3 -months.
Over the past decade, shorter-term returns were inconsistent, so the sector could take a breather to digest the gains.
Better economic reports may be a reason why
Dean showed that after a surge in positive economic reports a year ago, economists adjusted their expectations and subsequent reports failed to meet those higher standards. Now that conditions are (somewhat) normalizing, reports are once again beating economists' expectations.
In recent days, the Citigroup economic surprise index crossed above zero for the first time in more than 3 months.
This signal has triggered 11 other times over the past 18 years. After the others, future returns were positive across all time frames. A year later, the S&P 500 was higher 91% of the time, with one untimely signal during the financial crisis.
Low volatility is no reason to fear
Jay looked at the history for the VIX "fear gauge" with the 17 level as our cutoff between implied volatility being high or not.
The chart below displays the cumulative growth of $1 invested in the S&P 500 Index for trading days after VIX is above (blue) and below (black) 17.
Days above 17 have a higher total return, but days below 17 are overall much less volatile. The bulk of the last 3 bear markets occurred when VIX > 17. Yes, the stock market can decline when VIX is < 17, but the mere existence of low implied options volatility among S&P 500 stocks does not appear to be a factor in creating market weakness.
High-yield bonds are trying to recover
Bond investors - especially junk bond investors - tend to be hypersensitive to changes in default risk and economic growth. When these folks smell trouble, they sell first and wait for the smoke to clear.
It's worth keeping an eye on now because, for the first time in a long time, many of these bonds aren't confirming the move in stocks. The Cumulative Advance/Decline Line for high-yield bonds has been sliding for weeks as the S&P 500 continually notched new highs.
The 10-day average of advancing minus declining junk bonds dipped to an extreme low in mid-October and has attempted to get back to even.
Other times when the average recovered from below -350, HYG struggled for up to a month, then showed strong returns according to the Backtest Engine.
Other breadth indicators focused on the high-yield bond market are showing similar reversals from oversold conditions.
That these bonds are now recovering from moderate oversold conditions should be a good sign. It's just a bit worrying that so many bonds suffered substantial losses, something we hadn't seen since the pandemic panic. We will continue to monitor behavior in these bonds to see if they give a tip-off of potential risk-off behavior in the coming weeks.
Time for energy to rest
Seasonal trends for a couple of major energy contracts have been negative for a while, and that continues into January. Jay noted that the Annual Seasonal Trend for both crude oil and unleaded gas is for lower prices into the early part of the next year.
In addition, some indicators are pointing to lower prices for crude and unleaded gas.
The chart and table below display the performance for crude oil in the last 15 years when the 50-day moving average for crude oil Optix has dropped below 60 for the first time in 21 days.
In the past 15 years - which has seen tame inflation - crude oil was lower 12 months later each time. But since it was triggered in August, the contract is up more than 25%. A similar thing happened after the March 2008 signal, and that one ended up showing a massive loss over the next 9 months.
According to various generally reliable indicators, crude oil and unleaded gas should experience weakness in the months ahead. As a result, contrarian traders might look for opportunities to play the short side with a solid risk-management plan in place since these would be counter-trend trades.
If the energy contracts continue to rally and make further new highs, it would be a sign that inflation is a much more significant - and likely more persistent - problem currently believed.
Gold miners surge, but...
The go-to index for gold miner investors is the NYSE Arca Gold Bugs Index. BUGS stands for Basket of Unhedged Gold Stocks. The index contains companies that do not hedge their gold production beyond 1.5 years to better correlate to gold prices.
Dean noted that over the past week, the index has jumped more than 10%, within a couple of months of languishing at a 1-year low.
When the trend in the U.S. dollar was positive, surges in gold mining stocks have had a hard time holding.
This signal has triggered 12 other times over the past 52 years. After the others, future returns and win rates were weak in the 1-3 month time frame. And more recent history shows 7 out of 8 losses in the 1-month window.
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