S&P 500 The Most Overbought Since January 2018

Extreme Euphoria Develops

Stocks are way overbought. Many were too early in predicting a correction because they expected this to be a normal period where stocks get overbought and then selloff 3% to 5%. In fact, stocks are getting extremely overbought which means an even bigger decline is coming. 

As of Friday, the 14 day RSI hit 74.82 which is the highest point since the January 2018 peak. This index has only gone above 80 twice in the past 10 years. It’s highly unlikely to move more than a few points higher. Each time stocks rise, the situation moves more in favor of the bears.

On Monday, the S&P 500 was only up 5 basis points. That was enough to extend the streak without back to back losses to 29 days. It’s the longest streak in almost 8 years. Since the VIX only increased 0.41 to 12.46, the streak of it being below 15 was extended to 26 which matches the 2019 high. 

CNN fear and greed index fell 4 points to 83 which is extreme greed. Even though it has been falling, the amount it has been holding up is surprising. It usually moves very quickly off extreme greed. Even small rallies can’t keep it in extreme greed for long. Usually, it falls quicker because when it reaches extreme greed stocks usually fall.

S&P 500 is on its 34th 7 day streak of open to close gains since inception. Only 15 of those streaks have made it to 8 days. The record high is 12 straight days. Keep in mind, much of the gains in this bull market have occurred after the market is closed. This market is getting extreme. 

It’s near records you didn’t know existed. The chart below doesn’t include the last 4 trading sessions. But it still shows the market is extremely overbought. Crowd sentiment index is clearly above 66 which provides -3.2% annualized returns.

New Phase

It’s really tough to gauge this market because it’s extremely overbought, but it’s easy to see why that’s the case. Stocks love when the economy is near its bottom and ready to ramp higher again. By the time everyone sees the economy is doing well, most of the gains have been had. Technically, the global equity market is near a new bull phase. The chart below shows the MSCI all country world index since 2008.

As you can see, there have been 3 sideways corrections just as there have been 3 slowdowns. The market is near a breakout which makes sense because many investors see a cyclical upturn. MSCI ACWI ETF is at $77.46 which is just 8 cents below the record high. 

You don’t want to make a bet against a market that is just starting to breakout. However, sometimes even in those situations, it’s time for a pullback. Especially when things are getting overheated. I think we are at that moment since the S&P 500’s 14 day RSI is in the mid-70s.

Investment Banks Capitulate To The Optimism

It’s not surprising investment banks are chasing this market with their recommendations. They can’t be left too far behind. It’s extremely difficult to be a bear right now. It was very easy to be a bear in 2018. Credit Suisse initiated a 2020 S&P 500 target of 3,425 which is 9.8% higher than the current price. 

The firm sees a reversal of decelerating economics and multiple expansion. It sees industrial production growth bottoming this quarter; it upgraded financials, materials, energy, and industrials. It downgraded staples, utilities, REITS, and communications. The firm clearly sees higher rates coming.

Goldman Sachs is also bullish. The firm sees the Fed’s rate cuts helping the economy after a 3 quarter delay. That means growth should accelerate in Q2 and Q3 of next year. If rate cuts help the economy after 3 quarters, the Fed’s cuts were smart. Growth could potentially be below 1% in Q4. 

Next stop could have been a recession in 2020 without the cuts. Goldman is recommending cyclical stocks. Its list of 24 firms includes CBS, Snap-On, Kohl’s, Urban Outfitters, and TCF Financial. I get the optimism about the cycle, but it’s scary to buy stocks with the market at extreme greed. And, I’m guessing the AAII investor sentiment poll shows a much higher percentage of bulls in this week’s update.

Review Of Monday’s Action

Best 2 sectors on Monday were real estate and consumer staples which increased 0.5% and 0.54%. Even though the overall S&P 500 is exhibiting euphoria, that’s a defensive sector rotation. Worst 2 sectors were energy and healthcare which fell 1.33% and 0.38%. In the latest Iowa poll, Pete Buttigieg was up by 9 points. Since he’s a moderate, that’s good news for healthcare.

Nasdaq was up 11 basis points and the Russell 2000 was down 26 basis points. 10 year yield has fallen to just 1.80% as the bond market has abandoned the euphoria on accelerated economic growth in 2020. 2 year yield is at 1.6% as the recent small amount of flattening in the yield curve has continued. 

Fed funds futures market sees a 65.8% chance of a rate cut next year. That can’t happen in a cyclical upturn. Clearly, the stock market and the bond market disagree with each other. The chart below implies the bond market might be correct as more economic data has been missing estimates than beating them lately. Citi Surprise index has gone negative after its brief positive stint earlier this fall.

Conclusion

It’s clear traders are betting on improved economy. However, there needs to be a washout of this euphoria. I don’t agree with Credit Suisse that there will be another 9.8% gain next year after this amazing year (unless there is a correction soon). 

A lot of what is expected to happen is already priced in. Turns out, I was mistaken to be bearish before the RSI got above 70. Clearly, I was too early. Now, I expect a 5% to 7% decline because of how overbought the market has gotten. That can still happen even though the calendar effect is bullish.  

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