Stocks Are Extremely Overbought

Optimism Is Hyperbolic

Stocks rallied again Thursday as the S&P 500 was up 0.7% and the Russell 2000 was up 1.72%. The S&P 500 is now up 3.45% year to date. That’s an amazing month of returns and we’re only almost halfway through January. The CNN fear and greed index is at 77/100 which is extreme greed. This rally to start the year has been so amazing; I’m going to show many charts to get that point across. The chart below is the 30 day relative strength index in the S&P 500. This is from yesterday, so it’s a bit higher than indicated. The current 14 day RSI is 77.81. As you can see in the chart below, the S&P 500 has the most momentum in at least the past 4 years. It’s amazing to see that stocks are doing better than at any point in 2017 since that was in the 97thpercentile in terms of risk adjusted returns. The terrible January in 2016 is a long distant memory that’s unthinkable in today’s market.

 

The chart below is also from yesterday. I almost never check the Bollinger bands, but when action is this extreme, it’s interesting to look at them. As you can see, the S&P 500 is outside of the top end of the Bollinger band which means the market is 2 standard deviations above average. That’s a strong sell signal in the near term.

The chart below is the Investors Intelligence sentiment index. As you can see, the bull to bear reading as of Tuesday was at the highest point since 1987. This run from being at almost the most bearish ever to being near the most bullish ever is the most remarkable run in the history of this survey. Generally, it doesn’t make sense to buy at the top, but keep in mind this is a near term indicator. To me, it means a correction could be coming. However, falling 5%-10% doesn’t mean a bear market will arrive as the economy and earnings look like they will be strong this year.

While the Investors Intelligence survey is very optimistic, the NDR sentiment poll makes it look like investors are even more euphoric. As you can see from the chart at the bottom, the NDR is at 78.9% which is a new record. It indicates that when investors are optimistic, it’s bearish and when they are pessimistic, it is bullish. The indicator goes back to 1995 and was last updated on Tuesday. When the index is above 66, it means stocks lose 2.89% in the next year and they rally 24.47% of the time. Based on the break down, you’d assume the higher it gets, the lower the returns and the lower the chances of a positive return. This looks like the chart showing how low unemployment equals bad returns. Almost every indicator I see says long term returns are going to be low.

With that previous point about 1 year returns in mind, the two charts below show when the S&P 500’s RSI is above 70, the subsequent 3 month returns and 1 month returns are usually positive. This conflicting data might sound confusing, but I’d rather show the full picture instead of just the bearish information.

Oil Pressing Down Junk Yields

The only major asset which has more upward momentum than stocks is oil. As you can see from the chart below, oil has rallied from $25.73 to $64 in the past 2 years. Because energy firms dominate the junk bond market, it has been easy to see the negative correlation play out. As oil prices have increased, the high yield debt market has exploded to the upside. This goes along with the notion that rising oil prices is good for the economy as the U.S. produces more oil than it has previously. Production is supposed to hit a record in 2019. Obviously, that’s determined by price, so the estimates might not be realized.

Small Business Optimism In The Stratosphere

It’s rare to see an economic metric use the word stratosphere, but that’s what the latest NFIB survey has in its December report. The 2017 average monthly report was the highest ever in the 45 year history of the survey. The average was 104.8 which beat the 2004 record which was 104.6. The December report was 104.9. Looking into the specifics of the report, one metric which jumps out is that actual sales results went from a -5 last month to a +9 this month. That’s a 14 point positive swing. These stats are seasonally adjusted, so you can’t blame the holiday season for the positive results. The average increase from November to December since 2012 is 1.6, showing how this really was a great result. The holiday season was great.

As you can see from the chart below, the employment situation for small business is near the best it can possibly be. The net percentage of small businesses with few or no qualified job applicants is 54%. That’s the highest for this business cycle. 31% of small businesses have positions they aren’t able to fill. 20% are expecting to hire more workers. 23% are expecting to increase their workers’ compensation plans. That’s a 6 point increase from last month. Every chart you look at in this report looks like the situation can’t get much better. The optimism is disconcerting to me because when you’re at the top, the only way to go is down. At the same time, this optimism is justified because of the regulatory cuts which have been made in the past year. They were hurting small business’ ability to compete with large firms.

Conclusion

In the near term, I’m bearish as stocks have gone up in a straight line. However, this simply means there will be a bad few days which isn’t enough to ruin the year. As I said, Friday starts earnings season. Let’s see if estimates are beaten and stocks fall again. In the intermediate term, which is 6-18 months, the economy looks strong as it has momentum for the first time this expansion. With the help from the tax cut, I expect 2018 to be better than 2017.

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