Since early October, stocks have been steadily climbing higher as market conditions get frothy. Some of the factors behind the aggressive buying are indications that the economy is bottoming, easing of trade tensions, a dovish Federal Reserve, and relatively strong earnings. The S&P 500 (NYSE: SPY) is up more than 10%, and many stocks are making new highs such as big banks, homebuilders, housing material stocks, and retailers.
On an intermediate basis, there are several structural reasons to expect bullish conditions to persist including fund flows, investor positioning, and bullish year-end seasonality. However, in the short-term, market conditions have become less favorable despite prices levitating higher. Traders and investors should consider taking profits and being patient given these developments.
Bearish Developments
These types of relentless advances are interrupted by periods of extended, rangebound trading or sharp dips. Often these are more 'market rotations' rather than selloffs in which indices trade with low volatility, but there is significant churning under the surface as different sectors see inflows and outflows. Such a scenario likely awaits the stock market in the coming days and weeks.
One concern is that stocks are no longer hated. In early October, the CNN Fear/Greed Index sat at 20, and it recently hit 90. Other short-term sentiment and technical measures also show bullish extremes such as Daily Sentiment and the put/call ratio.
Despite the gains in broader indices, breadth is not expanding. In hindsight, the strength and bullish divergence in breadth was a harbinger for the rally over the past six weeks. Currently, we are seeing bearish divergences in breadth. The NYSE cumulative Advance-Decline line is not making new highs this week, even as the broader market makes new highs.
Similarly, the Russell 2000 (NYSE: IWM) which is made up of small-cap stocks, more leveraged to the economy, is diverging as well. Ideally, this index should lead higher, and participation should expand as the market climbs. Until it begins to expand and lead, it's prudent to be more selective about buying and more aggressive in taking profits or cutting losses.
Another warning that should not be discarded is the weakness in high-yield bonds (NYSE: HYG). Like small-caps, this group is also considered a leading indicator. It failed to make new highs and is starting to show serious signs of distribution.
Given the momentum in stocks, it's quite possible that near-term upside is not exhausted. However, it's no longer an attractive risk/reward proposition as it was a few weeks ago.