How frothy is the stock market?

Mid-week market update: Now that the Dow, S&P 500, and NASDAQ Composite have risen to an all-time high on the back of a slightly softer than expected CPI report, and Keith Gill, otherwise known as Roaring Kitty, and the meme stock brigade is back, how frothy is this stock market? Just look at the surge in the meme stock favourite, GameStop (GME).

I would argue that sentiment is not extended and indicative of a short or medium-term top. Let’s address the meme stock mania first. Recall that the prices of these stocks were driven up by concerted call option buying which forced option market makers to buy the underlying stock and drive up the price. If the raid is well-engineered, the meme stock brigade could create a price spike using only a small amount of capital, as call option prices are low compared to the underlying stock.

If that’s the case, why haven’t we seen a move in either the CBOE put/call ratio or the equity-only put/call ratio? The accompanying chart shows the 10 dma of both ratios and the pink shaded lines indicate episodes of excessive bullishness, which is not what we see today.

As well, Bespoke Investment Group pointed out that it wasn’t just GameStop that led the rally yesterday (Tuesday), but the most heavily shorted stocks. I interpret this as a broader factor-based rally rather than just meme stocks.

In the meantime, the S&P 500 has reached a new all-time high while exhibiting strong breadth (bottom two panels). As I’ve pointed out before, the market is undergoing an advance characterized by a series of “good overbought” RSI readings. Stock prices can rise further.

Here’s a corner of the market that is extended and due for a breather. Regular readers know that I have been long-term bullish on gold. Gold has staged an strong upside breakout through resistance. More importantly, the bottom panel of the accompanying chart shows that the gold/S&P 500 ratio is making a multi-year saucer-shaped bottom, indicating strong relative performance potential in the coming months and years.

Tactically, however, gold miners look extended and due for a correction or consolidation. GDX is exhibiting a negative RSI divergence, which has resolved in price weakness in the past, and the percentage bullish on P&F recently reached the overbought zone. While I am long-term bullish, my inner investor recently took profits in his GDX position and he is waiting for a pullback to re-enter his long position.

Both my inner investor and inner trader are bullishly positioned in equities. The usual disclaimers apply to my trading positions.

I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.

 

 

Disclosure: Long SPXL