Extreme wide reading predicts short-term weakness and long-term strength | a cautious investor

By the end of October, market conditions were truly dire. The S&P 500 index broke below the 200-day moving average for the first time since March. Only 10% of S&P 500 members remain above their 50-day moving average. This means that a full 90% were below this key short-term indicator.

What a change we have seen in the past six weeks!

This week, about 88% of SPX names are above their 50-day moving averages after briefly touching the 90s level on Wednesday. The S&P 500 hit another record high this year, ending the week just above 4700. That’s right. We are only about 2% below our all-time high!

So is the overly positive mid-December range good or bad for stocks? The reality is both.

Short-term upside appears limited

When we examine the percentage of stocks that are above their 50-day moving average, it seems clear that an upward extreme has been reached. This indicator rarely reaches the 90% level, but in fact it has reached it three more times in the past 18 months.

The last time we saw an extremely bullish reading was in July when SPX was testing the 4600 level. Over the next three months, the stock declined steadily, reaching a low near 4100 in late October.

At the end of November 2022, the index rose more than 90%, marking the S&P 500’s first rally since its October 2022 low. The benchmark fell for about four weeks before hitting a new high in February.

The third time we saw this level of positive breadth was in August 2022. At the time, S&P was testing its 200-day moving average below. This was the meat of the bear market phase of 2022, so this extremely positive reading was highly unusual. Of course, we were soon down to October lows for about eight weeks.

These three declines of 10%, 8%, and 17% respectively show that the breadth is very bullish and that the near-term outlook is actually bearish. All it takes is for the market to correct lower before continuing the previous trend.

But remember, these were all short-term declines lasting about 4 to 12 weeks. What are the long-term implications of this overbought pattern?

Long-term outlook remains positive

Returns 6 to 12 months after these signals occur have actually been shown to be quite constructive. Therefore, while in the short term it means that a downtrend is imminent, in the long term it means that the upward trend is alive and well.

Now we’re pulling in 20 years of daily data, and the bottom panel shows the percentage of S&P 500 stocks that are above their 50-day moving average. Whenever this indicator crosses the 90% key level, we’ve highlighted it in pink and also included a vertical dotted line at each mark.

You will notice that what we discussed above about short-term impacts generally applies across multiple cycles. We often see a decline immediately after reaching the 90% level, or at least a brief pause in the upward trend.

But now take a look at what happens about 6 to 12 months after these signals occur. In almost all cases, we see the market fully recover following a downturn, often reaching new highs within a year.

Now, let me be clear: a six-month decline is no small matter. Some people will say that if you’re on the wrong side, it could be a “career-destroying decline!” But when examining this period in market history, it’s reassuring to know that these signals ultimately led to a very happy ending for stock investors.

What to expect in Q1 2024

We are currently in the midst of one of the strongest seasonal times of the year, with November and December often experiencing strong returns for stocks. And in a pre-election year like 2023, this seasonal trend certainly appears to be in effect.

Just this week, we saw additional economic data suggesting that the Federal Reserve’s efforts to curb inflation appear to be working. Federal Reserve Chairman Powell’s comments Wednesday marked the latest uptick in this strong fourth quarter as investors priced the possibility that a “soft landing” would become an increasingly likely outcome.

Many risks remain for stocks in the first quarter of 2024, including rising interest rates, a surge in volatility, and the U.S. dollar’s return to its “shipwreck of risk assets” role seen in 2022. Given the strong market breadth in mid-December, I’d say the long-term outlook for stocks is stronger than ever.

RR#6,

dave

P.s Are you ready to upgrade your investment process? Check out our free behavioral investing course!

David Keller, CMT

Chief Market Strategist

StockCharts.com

disclaimer: This blog is for educational purposes only and should not be construed as financial advice. You should not use any of our ideas and strategies without first evaluating your personal and financial situation or consulting a financial professional.

The author had no positions in any securities mentioned at the time of publication. All opinions expressed herein are solely those of the author and do not in any way represent the views or opinions of any other person or entity.