Since the fourth quarter of 2022, the Dow Industrial Average, the S&P 500, and the Nasdaq Composite have maintained a prolonged bullish trajectory. Throughout the past eighteen months, stock fluctuations have been notable, yet the stellar performance of Alphabet, Amazon, Apple, Microsoft, Meta Platforms, Nvidia, and Tesla (the "Mag 7") has been a consistent highlight, not only in stock value but also in earnings.
Initially, the S&P 500 reported a 1.4% decline in blended earnings for Q4 leading up to the week of January 29th. However, following the earnings releases of Alphabet, Amazon, Apple, Meta, and Microsoft, the tide turned, propelling earnings growth to 1.6%. This growth further escalated when Nvidia announced its results, culminating in 3.2% earnings growth for the S&P 500 by February 16th, as per FactSet data.
While the market and earnings performances predominantly rely on a select few stocks, it's imperative to assess whether this prosperity and economic confidence can extend beyond the technology, communications, and consumer discretionary sectors. Alternatively, there's a possibility that these leading entities might “take five” momentarily, awaiting the next earnings season or significant catalyst to reshape the narrative.
Let's delve into the technical analysis of the prevailing market trends. It's evident that stock performance has been on a prolonged uptrend, having risen in 16 out of the last 18 weeks – a largely uninterrupted ascent. Momentum indicators signal overbought conditions and indicate bearish divergence, while options trading reflects a heightened level of greed. Moreover, the recent rotation away from growth stocks a couple of weeks ago acts as a warning sign that the rally might be losing steam. It's essential to note that this observation isn't necessarily bearish, as it disregards the broader context of the bullish trend off the 2022 lows. However, it suggests that a correction could be imminent based on certain conditions being met.
Momentum – Overbought and Diverging
Momentum indicators show us that the S&P 500 is overbought on the weekly charts. That can happen when the stock market is up 16 of the last 18 weeks straight with no mean reversion. Additionally, it's noteworthy that the weekly overbought readings coincide with the S&P 500 index touching the upper boundary of its trend channel. These two conditions may significantly influence buyers to exercise patience, awaiting potential price corrections, and prompt sellers to capitalize on profits.
While the weekly chart above shows overbought conditions, the daily charts show a divergence between momentum and price - that is to say, that the daily momentum indicator (RSI in this case) is lower today than it was weeks ago while price is higher. This can result based on traders buying and driving prices higher, but they are doing so with smaller gains on up days. It also may be a result of volume dropping off indicating a lack of conviction in the movement.
The combination of overbought conditions and bearish divergence momentum are two warnings signs that the current bullish trend may be tired and due for a correction.
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Options Activity – Greed vs Fear
I track several indicators to follow sentiment and breadth (participation) in the markets. One of those is following how many more calls or puts investors are buying to gauge bullish or bearish sentiment, respectively. Studies in options have shown that small investors typically trade in equity options whereas large and professional investors typically trade in index options, usually to hedge their portfolio. To get a feel for these two, I track equity put to call ratios as well as index put to call ratios. The current ratio of put to calls in equity options show that small traders in equity options are nearing levels associated with tops and greed versus bottoms and fear.
Growth vs Value
Growth stocks are companies that have low book-to-market-value ratios but have the ability to potentially grow their earnings faster over time to generate a return on assets while value stocks have a higher book-to-market-value ratio, lower growth of earnings, but often payout more of their cashflow in the way of dividends. The performance between these two can often signal the animalistic behavior of investors seeking growth or safety. Using the iShares S&P 500 Growth and Value ETFs, I can track the ratio to understand a trend.
For most of 2024, performance has been in favor of growth stocks. This could be because investors are bullish and they’re seeking outperformance in growth stocks. Value tends to outperform when economic growth is strong, and rates and prices are high. Growth tends to outperform when rates are low and economic growth is stagnated or weak.
There was a small and quick rotation out of growth stocks a couple of weeks ago. Nvidia’s earnings release last week largely turned that around, but some growth stocks are still off the highs a couple of weeks ago. This may be a signal, like the momentum indicators show, that buyers of stocks may be losing their conviction to press for higher prices and biding their time for a correction.
Defense
During stock market corrections, non-cyclical “defensive” sectors such as real estate, utilities, and consumer staples often demonstrate improved relative performance. Despite the rise in interest rates, how do these sectors fare? They're showing signs of improvement in February following a downturn in January. Their decline in January coincided with the realization that the Federal Reserve wasn't inclined to pivot aggressively with investor estimates for 6 rate cuts in the year. It looks more like three rate cuts in 2024 based on comments from Federal Reserve Officials. Consequently, long-term rates started to climb, which typically affects these three sectors. The recent uptick in defensive sectors in February, concurrent with a slight rotation away from growth stocks, could signify either a defensive rotation or a broadening of the current market rally.
Breadth Waning
The percentage of stocks within the S&P 500 that are trading above the 50-day moving average has softened since the beginning of the year. This indicator often triggers an intermediate sell signal when it passes through 70% from above, which happened in early February. Stocks have been trading higher since Nvidia’s earnings announcement, but a good chunk of the S&P 500 is no longer trading above this important intermediate moving average. This indicates that participation to higher highs in the S&P 500 has not been evenly distributed to all stocks, and the participation has narrowed. If this can get back above 70% and trend higher, we could see a broadening out of the current 2024 rally as investors rotate out of winners into other sectors.
Conclusion
There are several technical indicators here that communicate the S&P 500 cap-weighted index is extended and due for correction. Some of the indicators show that the index is extended, that momentum is waning, that investors have started to rotate out of growth, defensive sectors are turning up, and that participation has fallen in the ongoing rally to higher highs in 2024.
What does it all mean? These aren't signals to sell; rather, they serve as technical warnings. It's wise to consider rebalancing and realigning allocations to the initial targets you set for your stocks and stock sectors. If you own a stock that's underperforming, with deteriorating fundamentals, yet has risen alongside the broader index, it might be an opportune moment to consider divesting. Then, you will have some capital to reinvest in either sectors that see a new rotation, or patiently wait for the next buying opportunity in areas that are performing.
Advisory services offered through Financial Sense® Advisors, Inc., a registered investment adviser. Securities offered through Financial Sense® Securities, Inc., Member FINRA/SIPC. DBA Financial Sense® Wealth Management. Investing involves risk, including the loss of principle. Past performance is not indicative of future results.
