One such tool we've found to be particularly useful in identifying potential short-term tops and oncoming weakness is a simple breadth indicator we picked up from Pradeep Bonde and his incredibly useful website, StockBee. Within his daily Market Monitor analysis, he tracks the number of stocks that are up 50% in a month. The idea being that when you get an excessive reading in this gauge the market may soon take a breather. Generally, any reading higher than 20 starts to be considered excessive and we recently touched 25 on June 5th. Going back to 2013 (see chart) when this V-bottom market really kicked into gear we can see how this tool has served as a helpful guide for identifying short-term excess.
We went back and looked at all instances where the Stocks Up 50% in a Month Indicator hit a reading of 25. Looking out 10-days after such an occurrence, the returns on the Nasdaq averaged a loss of 1.7% versus a gain of .85% for all days during the data set. If we looked out 20-days from a reading of 25, the index averaged a loss of .78% versus another gain of 1.7% for all days in the data set. The evidence presented during the last few years has shown that when this indicator is stretched, buying stocks has been a low probability bet in the short-term.
Further, we typically see this reading become overheated after a strong move up in the index as this is a natural tendency of momentum and breadth. However, what's striking is the divergence that's taking place right now. Essentially the markets have gone sideways for months but underneath the surface we are seeing some impressive moves in individual names.
While a few of these single stock surges can be attributed to the booming M&A environment, the indicator has remained elevated (above 20) for multiple weeks now. So a question that looms for us is: will this high number stocks up 50% in a month eventually lead to some degree of selling in order to flush out the excess or will the broader market play catch-up so as to reinforce the moves in these individual names? Is the strength in certain individual stocks a clue that the current consolidation wants to eventually resolve to the upside??
If the resulting move is in fact higher, it would serve as a reminder that markets/indicators can stay overbought for extended periods especially during sustained directional moves.