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Has The Bull Market In Stocks Gone Too Far?

The most recent survey of the American Association of Individual Investors reached a 16-week high recently, as many broad market indexes registered all-time highs. Specifically, 49.4% of respondents said they were bullish and only 23.5% were bearish. While this is lower than the bullish reading of 55.8% recorded in November of 2020, it is well above the historical average of 38.0% bulls. Still, about half of investors surveyed are either neutral or bearish. Based upon my conversations with traders and portfolio managers, those who are not bullish are concerned that valuations are simply too high and that the euphoria associated with the potential end of the pandemic might be replaced by growing concerns with debt and inflation.

Back in August of 2020, I asked the question of whether the bull move was due for a correction, given the rise in the number of stocks making fresh short-term new lows. I cited original research suggesting that market corrections are often preceded by breadth weakness: before the overall market becomes weak, we often see individual stocks and sectors rolling over. Indeed, we did see a correction over the next two months before the bull resumed.

So what is market breadth telling us about the current stock market? Statistics from the Index Indicators site find that, this past week, we saw 80+% of stocks in the Standard and Poor’s 500 Index close above their 10-day moving averages and 80% above their 200-day averages. What this means is that the great majority of shares have been strong on both a short-term and longer-term basis—very impressive breadth. Going back to the start of my database in mid-2006 (over 3600 trading days), we find only 135 days with similar breadth extremes on a 10- and 200-day basis. Interestingly, these occasions have tended to cluster, with 11 instances occurring between February and April, 2007; 37 instances between July and December, 2009; 19 instances occurring between February and April, 2010; 13 instances occurring between February and April, 2011; and 27 instances between March and July, 2013. We’ve only seen this kind of strength happen on five trading days between 2018 and 2020—it’s not something recent investors are accustomed to seeing.

Across the 135 occasions in which we’ve seen 80+% of stocks closing above their 10- and 200-day moving averages on the same day, the Standard and Poor’s 500 Index closed up 20-days later 96 times and down 39 times, for an average gain of over 1.3%. That is about twice the average return of all other occasions. For the 26 occasions when this breadth strength occurred for the first time in at least a month, longer-term returns (next 50 days) were quite positive: 18 occasions up, 8 down for an average gain of over 2%. This nicely complements other research I have conducted, which shows superior 20+ day returns following days in which very few stocks register fresh short-term price lows. Across all exchanges, according to the Barchart site, only 16 stocks made new three-month lows on Friday. On average, it is difficult for the overall market to roll over when the great majority of individual stocks are displaying strength.

Of course, markets are probabilistic enterprises and idiosyncratic risks can impact any market and cause it to deviate from historical norms. An important takeaway here is that, just because the market has been very strong doesn’t mean it is necessarily due for a meaningful correction. The tendency of breadth strength to cluster across multiple occasions is a function of strong long-term trends, and it is conceivable that we are in the midst of such a trend at present. The best data explorations, I find, are good for trading psychology: raising promising questions as well as suggesting answers.

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