Santoli: Record-breaking rally may be overheating

Published Wed, Jul 13 20167:44 AM EDTUpdated Wed, Jul 13 20168:47 AM EDT

When a market that's spent more than a year in the red finally breaks to a fresh all-time high, it's not just a fluke. The major indexes made dozens of approaches of their May 2015 records and declined every excuse to surmount them, so the current upside breach should at least be respected. And the rally, which has lifted the Standard & Poor's 500 and the Dow Jones industrial average to previously unseen heights, appears pretty sturdy: The vast majority of stocks are participating, credit markets are supportive and the longer-term trend has turned up. Still, the ascent has been so steep that even believers in the breakout should be watchful for signs that this leg of the rally is growing overheated or fatigued. The S & P 500 is up 7.6 percent in the past 10 days beginning after the two-day tumble after the shock of the U.K.'s vote to leave the European Union — a searing-hot pace. That's the best 10-day run since late 2011, when markets were recovering from the severe correction during the twin European credit and U.S. debt-ceiling crises. According to market-data cruncher Sentimentrader.com, more than 70 percent of NYSE trading volume has been in advancing stocks for just the second time in 20 years. The last time was March 23, 2009, as the market surged off its ultimate bear-market lows. That's not nearly enough history from which to draw any inferences about direction, but it's a decent signal of how rare the lopsided bullish skew has been. To handicap whether this move is about to stall or pull back, tactical traders and market trackers will be focused on technical indicators, sentiment snapshots and clues from other asset markets. Chart watchers generally endorse the foundation of this rally. Some of the main immediate beacons are just how stretched the index becomes above its general trend. Mark Arbeter, head technician at Standard & Poor's, notes the "slope needs to reset" after such a vertical spurt, but that can happen through a slowing of the advance or some sideways-to-down action. The index is about 3.6 percent above its 50-day average, which is not in itself alarming. On Halloween, just as the autumn rally was about to roll over, the index was 6 percent above its 50-day trend. That would be more of a warning signal, though the index is looking a bit more extended versus its longer-term averages. Jeff deGraaf of Renaissance Macro Advisors says he's still monitoring the percentage of individual S & P 500 stocks that are making a new 20-day high. He would like to see the tally get above 50 percent to conclude that the rally is truly sustainable. So far, it's only climbed to 30 to 40 percent. Investors have been cautious most of the year, as indicated by fund flows out of equity funds and largely muted optimism in investor surveys. And they grew fairly panicky in the immediate aftermath of the Brexit vote. Now that stocks have rebounded so ferociously, it's time to look for signs of excessive speculation and overconfidence. So far, we're seeing only stirrings in this direction. The CNN Money Fear & Greed Index, a composite of market-based measures of sentiment, is at 88, well into the Extreme Greed zone and higher than it's been in nearly two years. Willie Delwiche, strategist at Robert W. Baird, points out the Ned Davis Research daily sentiment reading is "quickly rising" toward over-bullish territory. And while the breakdown of bearish versus bullish options volume — the so-called put-call ratio — has dropped dramatically, its multiweek average has yet to fall to levels that usually mean a market move is maxed out to the upside. Source: FactSet The widely watched and much-debated CBOE S & P 500 Volatility Index , or VIX, is in an interesting spot. In the past month, this gauge of options' traders demand for downside protection surged from 13 to 26 (in the Brexit sell-off) and then collapsed to 13.5. This mostly reflects a more stable market, though at extremely low levels also shows trader complacency and susceptibility to sharp market pullbacks. On this score, Delwiche said, "a sub-12 reading would really get my attention." What's interesting now is that the VIX, which typically moves opposite the S & P 500, was up (slightly) two-straight days even as stocks have rallied strongly. In a study from a few years ago, Russell Rhoads, director of education at CBOE Options Institute, found that such two-day anomalies have a slight downside bias over the next five days, but the up/down split was not much worse than a coin toss. Larry McMillan of McMillan Analysis said: "Once again, traders seem reluctant to allow VIX to go below 13. Regardless, as long as VIX is not in an uptrend, stocks can continue to rise." Other sentiment smoke signals? A sudden rush of cash into stock funds, especially aggressive ETFs, would suggest the public chasing the move. And how about Wall Street strategists? They entered the year somewhat cautious and have stayed that way. The average year-end S & P 500 target among this traditionally bullish group is 2,150. Tuesday's closing level was 2,152. So watch for some of these folks to start lifting their targets as a sign that skepticism is being wrung out of the market. While no immediate threat to any rally, it would make the bullish case less a maverick position. Treasury yields finally have lifted from all-time lows this week, the 10-year note yield climbing to 1.51 percent from 1.36 percent Friday. While there's no magic level of interest rates that are good or bad for stocks, the relationship is fragile: If Treasurys begin to rally hard again, it could call into question the brighter economic and policy tidings implied by the equity rally, while much higher yields would undercut those dividend stocks that have done so much to carry the market higher. Oil's link to stocks has loosened a bit, as the orderly pullback in crude has not yet been enough to rattle equity traders. Any steeper drop in oil to the low-$40s per barrel that goes ignored by the S & P 500 for a day or two might open up an air pocket beneath stocks. Perhaps more crucial for stocks is how credit indicators behave. High-yield bonds have been impressively strong, their risk spreads to Treasury yields compressing nicely. Any serious reversal here would suggest a halt to the up-welling of risk appetites that have aided the stock market in recent days.

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When a market that's spent more than a year in the red finally breaks to a fresh all-time high, it's not just a fluke.

The major indexes made dozens of approaches of their May 2015 records and declined every excuse to surmount them, so the current upside breach should at least be respected.

And the rally, which has lifted the and the Dow Jones industrial average to previously unseen heights, appears pretty sturdy: The vast majority of stocks are participating, credit markets are supportive and the longer-term trend has turned up.

Still, the ascent has been so steep that even believers in the breakout should be watchful for signs that this leg of the rally is growing overheated or fatigued.