New Highs - Now What?

It has been a volatile few months with the markets straight down in May only to rally in a V-shaped manner in June.  The S&P 500 is back testing new highs as this is the third test of highs going back to September 2018.  So far the last few months have played out nothing like the historical average.  Going back to 1950, the average May shows a gain while June shows a loss.  July remains one of the stronger months while August is the second weakest month.  How with the rest of the summer play out? 

One primary concern of many investors is the lagging performance of small caps.  It is last index not at or close to new highs. It remains well below the September 2018 high.  See the bottom right chart.

However, the Russell 2000 underperformance should not be a primary concern according to a study from Mark Hulbert.

Another great post from Urban Carmel at the Fat Pitch Blog highlights why investors should be more worried when small caps lead.  "By contrast, small caps are lagging. They have retained none of their gains made over the past 1-1/2 years and haven't been close to a new ATH in 10 months. Should investors be worried?  By most measures, the answer is probably not. Small cap underperformance has more often marked a low in SPX, not a high. Investors should be more worried when small caps - which are highly speculative and high beta - lead, as this has most often been a feature of major bull market tops, the reverse of the situation we have now."

One of the measures we follow to get a general sense of participation is breadth.  There remains some conflicting signs.  While the cumulative A/D line is advancing to new highs with the S&P, there are a number of other contradicting breadth measures. 

The percentage of S&P stocks trading above their 50 day moving average peaked in the first quarter and has yet to take out new highs along with the market. 

The number of stocks making 52 week highs on the S&P peaked June 7th during the start of the current rally.  It has made lower highs as the S&P is making higher highs. 

Another indicator we track and follow is a measure of overbought/oversold conditions.  We track the amount of stocks up 50% in a month.  This gives us a good idea of when a market gets excessive.  As with all indicators you have to take them in context.  Overbought signals at the beginning of a trend can be viewed positively.  However, if you get them after an extended run they can signal exhaustion. If we study the table below it gives a few clues.  We looked at every instance since 2010 when the indicator first reached overbought levels.  We removed the clusters.  The returns are weaker against the whole sample in all four time frames.  Going out 10 and 20 days is the biggest divergence in returns. 

As we remain in the challenging 6 month stretch of May through October we look to secondary indicators to confirm the trends.  The trend remains up and bullish as most indices are at or close to new highs.  Small cap underperformance shouldn't be viewed as big as a negative as the pundits make it out.  The A/D line is a broad measure confirming the trend.  However, for the markets to sustain and ultimately blow through new highs on the upside we'll need to see the secondary indicators participate. 

Have a great 4th of July!