The rally is on, or at least so it seems. While the vast majority of market participants (amateur and professional) and media outlets have declared a new bull market, it always pays to look beyond the indices at two things – leading stocks and their price-volume action, and market breadth.
Basically, a strong market is both broad in its rallying constituents and in the amount of opportunity it offers in novel leading stocks pacing fast ahead with commitment. If there is no breadth, single point events in small market segments can easily derail the markets – if there are few to no leading stocks, there is no opportunity for a speculator.
And both are nowhere to be seen.
As I argued last week, this rally is out of touch with reality, showing a lot of signs of previous tops or false bear market rallies.
While a small amount of extremely well-capitalized tech companies (the mega-8) along some low-quality AI meme 2.0 stocks and a cyclicals rotation is driving the popular indices (NASDAQ-100, S&P500), there is a massive divergence forming. While the indices head up, the amount of stocks driving the rally is headed down.
The Chicago Board Options Exchange (CBOE) publishes a metric termed COR3M, which is a derivative-based estimate of the correlation of the S&P500’s top-50 stocks for the next 3 months.
In other words, it’s an insight how broadly stock bets are placed by market participants across the top-50 companies in the SP500. This is now at a multi-year record low of 17.6, an astoundingly narrow degree of concentration and groupthink. Also note how COR3M has collapsed to this extreme in neat and eerie lockstep with the start of the NASDAQ / SP500 rally last October, and has become particularly steep since the Fed’s bank bailouts and liquidity provisions in March:
Though a dropping correlation / rising concentration is not always a problem as seen in the 2020 and many other strong market trends, and can offer large selective opportunities for stock pickers, it’s the rare extremes on the downside that are red flags.
Last time COR3M was this low was in early 2018, imminently preceding heavy volatility and a rapid 12% collapse in the SP500 over 12 days (the “Volmageddon”) – really quite momentous:
As the COR3M is based on expectations of the options market, this is not only a descriptive narrative of what’s going on – it’s an insight into the causative psychology behind this move.
People are betting only on this small amount of stocks, while the rest of the market is in the doldrums: As the capitalization-weighted SP500 has performed 18% YTD, the equal-weighted version has only achieved 9%. And the bummer – the top-10 stocks in the SP500 (i.e. the top 2%, including the mega-8) are responsible for driving roughly 32% of this index move!
Right now, the majority of the large players that had placed bearish bets on the rally have cried uncle, while the hyped FOMO “investors” that are talking it up are already in it, and have no power left other than talking it up more. This should prompt anyone managing risk to ask what firepower is left to truly drive this market further.
As I wrote on numerous occasions before, such rallies can go on much longer than most would think (i.e. until the last disbelieving bears have capitulated). Especially here, point events are needed to rattle the market and bring home the volatility – if none occur, the rally happily goes on. But should one appear, the ‘intensity threshold’ of negative reactions following it required to topple the boat is very low, hence the precariousness of such narrow rallies.
Again, that doesn’t mean you can’t make money – but it won’t be a lot, and odds are a pullback later you’ll be back at zero … or less. In short, the market might be tradable for some, but it’s sure not highly profitable.
For me though, the mere absence of actionable leading stocks is enough of a shot across the bow for anyone perusing the stock market for purchases to tread very carefully.
