Are US Equities Heading Back to New Highs?

As Sir Isaac Newton observed about inertia, “An object at rest stays at rest, and an object in motion stays in motion until acted upon by an outside force.”

Likewise, similar observations can be made for US equity markets throughout 2017.

Over the past several months US stocks have built and sustained inertia commonly referred to as momentum in the investment business.

In other words, the phenomenon of momentum suggests that positive price performance over a pre-specified look back period is often followed by more positive price advances in the future, and vice-versa for periods of underperformance.

S&P 500

For example, over the past 3, 6, and 9 month rolling periods the S&P 500 (SPX) built positive momentum that created an uptrend exhibiting sustained buying demand. That is, any pullback in price remains short-lived before SPX quickly advances again to new highs.

Most recently, SPX topped out around 2480 in late July to early August 2017 before retracing to re-test previous support around 2420 that was formed from June through early July 2017. Despite the -2.4% drawdown in SPX throughout August, the index has again displayed resiliency over the past week by engulfing most of the prior month’s range in three days bringing the index to close just below new highs.

However, on Friday SPX backed off from new high territory to close in the lower half of its day’s range and formed an inverted hammer for the day. This behavior is typically indicative of a price that is not yet ready to move higher and could indicate a near-term reversal.

In other words, until SPX closes above 2480 we have yet to observe evidence that a broad representation of equities is participating in a move higher.

Nasdaq Indexes

Elsewhere, the technology-heavy Nasdaq (COMPQ) and Nasdaq 100 (NDX) indexes did post new closing highs for the week as they are clearly being bolstered by the relative outperformance of the technology sector.

However, seeing the price follow-through to new highs while simultaneously posting an overbought reading on the daily Relative Strength Index (RSI) will add confirmation in the sustainability of the uptrend.

If RSI does not reach an overbought level, traders should look for any possible negative divergence that may be underway, implying internal price weakness.

Emerging Markets

Taking a look around the globe, Emerging Markets (EEM) printed new highs this past week continuing to trend upwards in an orderly manner. Again, steady, methodical trends are typical of a market displaying characteristics of sustainable price momentum.

However, EEM has advanced nearly uninterrupted since the beginning of 2016 and is now facing multi-year resistance from 2012-2015 at 46.00. Accordingly, on an absolute basis, EEM may begin to slow its positive price momentum in the short term if it cannot close above this previous level of resistance.

From a relative perspective, EEM continues to outperform SPX thereby offering more attractive investment opportunities on a comparable basis. Although, the relative strength line between EEM and SPX is encountering its own overhead resistance dating back to a previous support level during November 2014.

From a tactical perspective, Emerging Markets may exhibit some relative underperformance versus US stocks due to stalled price action on an absolute basis.

Small Caps and Transportation

Two areas of the market that are lagging the relative performance of the aforementioned indexes are small cap stocks, represented by the Russell 2000 (RUT), and transportation businesses, depicted using the Dow Jones Transportation Average (TRAN).

During late July 2017, both RUT and TRAN led stocks to the down side. While SPX traded along all-time highs before pulling back less than -3%, RUT and TRAN formed an orderly downtrend until each index closed below its respective long-term trend indicator, the 200-day Simple Moving Average (200SMA).

During these price reversals, strategic asset allocators can use the pull backs as buying opportunities since the slope of this moving average remains up. In other words, without a meaningful change in the long-term trend direction as delineated by the 200SMA, any transitory reversals of price toward this moving average can be considered volatility to ignore.

However, in the coming weeks and months, if RUT and TRAN do not follow the leading indexes by getting bid up to new highs as well, there will be the reason for concern regarding the sustainability of the long-term uptrend in equities without broad index participation.

Final Thoughts

Despite his accomplishments as a physicist, Newton was not known to be a profitable trader. In fact, he succumbed to several behavioral biases during the Tulip Bubble in Holand during the 1700’s. For example, confirmation bias and comparison bias lured Newton to invest in Tulips as the prices sprouted higher and his friends harvested the rewards.
However, the real fault within his investment strategy was not buying a market making new highs but his lack of an exit plan.
In short, Newton could have heeded some of his own advice on the physics of inertia and protected his wealth when Tulips prices began to Wilt.
Similarly, as traders, we are often compared to a peer group or benchmark and may find ourselves tempted to chase performance in particularly strong bull markets like 2017.
However, no matter if US equities and Emerging Markets move higher or lower from here the key as a trader will be to continue to run a robust strategy that aligns your portfolio with the dominant trend in each market until presented with a reason to sell due to an outside force changing its direction.

John DiRico is a trading and investment professional focused on technical analysis as well as alternative investment strategies. Additionally, he is the founder of the blog “A Discounted View” where he offers his observations on markets based on industry experience and topics covered in the Chartered Market Technician (CMT) curriculum. Please feel free to connect.