Liz Looks at: Rally Breadth
By: Liz Young · October 20, 2022 · Reading Time: 5 minutes
A Breadth of Fresh Air?
After suffering a painful September (S&P 500 -9.3%), October’s month-to-date performance of +3.1% feels pretty spectacular. At the time of this writing, the S&P strung together three days in a row of advances for a week-to-date return of +3.1%, causing many to ask themselves: “Is this the first week of the rest of our lives?” Ok, maybe that’s overly dramatic. But investors are at least asking whether this recent rally has staying power and what we can look at as a guide?
Many look at breadth indicators, which measure how much participation there is in market movements, to determine how strong or weak those trends may be. The most common breadth indicator measures the number of stocks that are advancing and declining on a particular day. In a rally, you want to see broad participation in the upswing to show that buyers are spreading the wealth (pun intended) across multiple stocks, sectors, and industry groups — rather than just a couple big stocks or sectors that can mask weakness elsewhere.
The chart below looks at the ratio of the two (number of stocks advancing / number of stocks declining) and is a bit noisy, but hang with me. In an effort to find outliers, or possible signals of notable strength, we drew lines at +3 standard deviations and +5 standard deviations above the average.
Good news: we hit an extreme of +5 standard deviations on Oct 4th. Bad news: that’s not necessarily predictive of positive forward stock market returns. For example, on Oct 13, 2008 this ratio was just as high, and the S&P dropped 13% in the following three months. On Dec 16, 2008 this ratio was again at +5 standard deviations, and the S&P dropped 17% in the following three months…on the heels of a Fed rate cut, to the lowest rate ever (0%).
In Animal Spirits we Mustn’t Trust
Animal spirits in investing refer to the power of herd mentality, and the tendency for investors to be overtaken by the “spirit” of the moment regardless of whether it makes rational sense or not. The rise of stocks during the dot-com bubble is an example of this. As are some of the extreme stock market crashes that have occurred, one of which we just saw the 35th anniversary of, the crash of October 19, 1987 when the Dow Jones Industrial Average plummeted 23% in a single day.
But there will always be outliers, and this chart shows a slightly more rosy picture. Since mid-2004, the advance/decline ratio has hit +5 standard deviations 32 times. Below is the distribution of 3-month forward returns on the S&P. Not always positive, but many of them are.
That’s when you have to take the environment into account and know the risks that still lie ahead. Animal spirits can be powerful, and they occur in both bull and bear markets. Bear market rallies can also be powerful. We can’t trust either as durable signals, and so far, we don’t have a clear sign that this recent rally is anything different.
(Cue the critics who will call me negative Nancy, or my personal favorite, “Lower Liz”)
Here’s the thing—the sooner we get to extreme pessimism, the sooner we move through the cycle and restart. With inflation still as high as it is, earnings that have barely budged lower, and a market P/E sitting around its 15-year average, it’s hard to convince me that we’ve hit extreme levels of cynicism.
Pounce When Ready
But you’re not going to catch the bottom and neither am I, nor will I even try. We’re closer to the end than we are to the beginning, and the more bear market rallies we see, the fewer are left before we finally flush it all out. This earnings season and next could be pivotal points in the cycle when companies clear out the dirt and set realistic expectations for 2023. Economic data could weaken further into the end of the year and start to take care of inflation. Still some more things to check off the list, but if/when earnings crack and just before economic data falls into contraction conditions, is when you start to pounce on market opportunities. That could be just around the corner.
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Communication of SoFi Wealth LLC an SEC Registered Investment Adviser. Information about SoFi Wealth’s advisory operations, services, and fees is set forth in SoFi Wealth’s current Form ADV Part 2 (Brochure), a copy of which is available upon request and at www.adviserinfo.sec.gov. Liz Young is a Registered Representative of SoFi Securities and Investment Advisor Representative of SoFi Wealth. Her ADV 2B is available at www.sofi.com/legal/adv.