Should You Embrace the Melt-up?

I pointed out last week that animal spirits were returning to the market. Perhaps too much. A recent Bloomberg article, “‘Irrational Exuberance’ Stock Gauge Sparks Fresh Bubble Worries”, tells the story of extremely greedy sentiment creeping into the markets. The Barclays Equity Euphoria Indicator has reached dangerous levels of froth:

The bank noted that the measure, which is calculated from derivatives metrics, volatility technicals and sentiment signals inferred from options markets, has historically averaged around 7%, but occasionally it peaks above 10% as during the Dotcom era of the late 1990s, and the meme-stock frenzy of 2021. The gauge currently sits around 10.7%, data compiled by Barclays show.

Market conditions are becoming bubbly and melting up.

At the moment, the S&P 500 is a little extended while grinding out new highs and it’s on an upper Bollinger Band ride. Should traders embrace or fade the melt-up?

 

 

 

A Sustainable Advance

To make a long story short, the odds favour further gains in the next few weeks. For some context, I use RRG charts to tell the story. Relative Rotation Graphs, or RRG charts, are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.

The RRG chart of U.S. factor returns shows the technical underpinnings of the latest bout of market strength. In the leading quadrant investors can find the high beta and high-octane factors, such as speculative growth, large-cap growth, high beta and price momentum. Not far behind in the improving quadrant is the small-cap Russell 2000. By contrast, the lagging quadrant contained value and defensive groups such as large-cap value, low volatility, high quality and dividend aristocrats.
 

 

The high-octane rally didn’t just appear overnight, factor rotation analysis showed that it had been developing for some time.
 

Another element that’s supportive of further market strength is evidence of broadening breadth. Market leadership is widening to small-cap stocks. The Russell 2000 staged an upside breakout of an inverse head and shoulders pattern, with a measured objective of about 250. In addition, the bottom panel shows that small caps are on the verge of a relative breakout.
 

 

 

All Systems Go

Other market internals are supportive of further gains. My technical dashboard is blinking mostly green.
Risk appetite indicators are confirming the stock market’s strength. Both equity risk appetite, as measured by the ratio of high beta to low volatility stocks, and credit market risk appetite, as measured by the relative price performance of junk bonds to their equivalent-duration Treasuries, are rising in lockstep with the S&P 500.

 

Option sentiment is not stretched. CBOE put/call ratios are in neutral, indicating a lack of exuberance despite the recent market rally.
 

 

 

Neutral Positioning

Estimates of market positioning are in neutral. If momentum continues to dominate, there is additional buying power for stock prices to run.

Deutsche’s estimate of aggregate equity positioning shows exposure recovering from a “Liberation Day” panic low, but readings are neutral and not excessively high.

 

Similarly, Goldman’s estimate of CTA global positioning tells the same story of a recovery from a panic low to neutral levels.
 

 

The AAII monthly asset allocation survey measures retail sentiment and indicates what respondents actually do with the funds, which is different from its weekly opinion survey of respondents think, shows rising of equity allocation after the recent market panic. However, readings are not excessive and have more room to grow.
 

 

 

Time for a Breather?

It’s impossible to forecast how the far the latest rally can last. I can point to some clues and risks that equity investors bear in the current environment.

One key risk is the Trump collar. The stock and bond markets have discovered Trump’s pain threshold at which he executes a policy pivot. The most recent pivot occurred in the wake of the “Liberation Day” panic when he moderated his stance on trade. That’s the strike price of the Trump Put. On the other hand, the market also needs to be aware of the Trump Call, when the markets are riding high and he feels more comfortable about displaying his dominance. Conceptually, it could be said that the market is financing the protection of a Trump Put with the sale of a Trump Call, which is known as a collar among option traders.

Recently, Trump has scored two big wins. The first was the passage of his tax bill, and the second was evidence of some progress in trade agreements, such as with the UK and Vietnam. The current setting may be ripe for the markets to recognize that it’s short a Trump Call.

U.S. market leadership has recently shifted from NASDAQ 100 stocks to smaller and more speculative names. While this may be a warning of unsustainable froth, I would point out that the relative performance of small caps has been correlated with my trade war factor since the November election. While correlation doesn’t represent causation, the relationship makes sense as smaller firms tend to be more sensitive to swings in economic outlook, including trade.

Trade war anxiety fell last week when the Trump Administration announced a trade deal with Vietnam and it was close to a deal with India, but can the easing of trade tensions last? A crack in the relative performance of small-cap stocks could be an initial warning of a possible stall in the market advance.
Already, the Trump Administration announced that it would be sending out letters in the next few days to countries detailing their tariff rates that range from 10% to 70% after the 90-day pause on the “Liberation Day” tariff rates expire.  Equity futures and the USD weakened after the news hit the tape, but trading was thin during the holiday hours and the market reaction next week will be a test of risk appetite.
 

 

The recently passed budget bill also contained hidden elements of a short Trump Call when it raised the debt ceiling by $5 trillion. The increase of the debt ceiling will mean that the U.S. Treasury will start to sell debt to finance the deficit and cease its previous extraordinary measures to avoid reaching the government’s old self-imposed debt limit. In practical terms, the government will reverse the drawdown of the Treasury General Account at the Fed, which supplied liquidity to the financial system, and drain liquidity by selling debt into the market. The withdrawal of liquidity will pose a short-term headwind to equity prices.
 

 

It’s time for a breather. The stock market is overbought in the face of growing risks. If stock prices were to wobble because of either of these two conditions in the coming days, I will be monitoring how risk appetite behaves under those conditions. Will the market pull back and correct, or will it shrug off these potential potholes and continue to advance? Stay tuned.
 

 

In conclusion, the market is taking on bubbly characteristics. However, momentum is still strong and sentiment is not excessively stretched. The market is due for a short-term pullback or consolidation. I believe traders should buy the anticipated weakness next week and embrace the bubble conditions as the melt-up has further room to run.