How To Tell If A Melt-Up Is Underway

Summary

• There is increasing talk among pundits of a stock market “melt-up” being underway.
• Pundits fail to consider market velocity and investor sentiment factors when making this assessment.
• Four signs should be present which confirm a melt-up. None are currently evident.

With the end of October comes the end of what Stock Trader's Almanac calls the "worst six months" for the Dow and the S&P 500 (SPX). The period between November and April is generally regarded as the best six months to be invested in equities, and that time is now upon us. In this commentary we'll examine the prospects for continued gains in the SPX in spite of already elevated stock price levels. I'll also attempt to answer the question that seems to be in the forefront of everyone's minds, namely: "Is a melt-up underway in the stock market?"

While the Dow and SPX have registered seven consecutive months of gains, the NASDAQ has logged only four straight monthly gains. Perhaps not surprisingly, it was the laggard NASDAQ which surprised traders in late October with a breakaway rally to new highs, leaving other major averages in the dust. The powerful performance of the tech sector lately has already inspired more than a few analysts and pundits to declare that a NASDAQ-led "melt-up" has started.

Among them is Jeffrey Saut, chief investment strategist at Raymond James. He argues that the S&P 500 "now appears to be involved in a melt-up." He further said that the market appears to be in its "upside 'blow off' stage." He added, however, that the secular bull market which Raymond James has embraced since October 2008 remains intact, with stocks in the "second leg" of the bull run that started in February 2016, adding his view that stocks have "years left to run."

What exactly is a "melt-up"? Investopedia defines a melt-up as a "dramatic and unexpected improvement in the investment performance of an asset class driven partly by a stampede of investors who don't want to miss out on its rise rather than by fundamental improvements in the economy." The implication for investors is that melt-ups tend to be followed by equally dramatic and unexpected declines once the market rally has exhausted itself. For that reason they are universally feared as "market events" to be avoided by investors.

The well known economist, Dr. Ed Yardeni, has also warned that a melt-up is a distinct possibility for the U.S. stock market. In a blog posting earlier this year he wrote, "My long-held concern is that the bull market might end with a melt-up that sets the stage for a meltdown." Yardeni has pointed to net fund flows into ETFs as corroborating evidence that a melt-up might be in formation. More recently, he was quoted in a CNN Money article as saying, "Right now, it feels like the early stages of a melt-up."

The financial media can't resist the temptation to remind investors that market conditions are ripe for a melt-up. An Oct. 29 Wall Street Journal article pointed out that stock market declines have grown shallower since 2015 and are revering quicker than normal. WSJ quotes a study by LPL Financial, which points out that the S&P 500 Index (SPX) has gone 249 trading days without trading more than 3% below its record high, the longest streak ever for the index. The index also hasn't had a decline of 10% or more from a recent peak since February 2016.

Source: www.BigCharts.com

The WSJ article also points out that investors are buying dips much faster than they used to. It mentions that the S&P recovered the bulk of its 5.3% decline in only three days after the Brexit was announced in June 2016. It also took three days for the SPX to recover from a 1.8% drop in May after the Donald Trump-James Comey investigation scandal. "That is a faster recovery than when the S&P 500 fell 11% over a six-day stretch in August 2015 and then took until November of that year to get back to its pre-selloff level," according to WSJ.

The melt-up definition that most observers seem to agree on is based mainly on rising stock prices. Missing from this definition is any reference to the velocity of the market's rise, as well as the overall level of participation among small investors. Both of these factors are crucial to the development and continuance of a genuine melt-up.

If we consider participation, a case can be made that the market rally of recent years hasn't enjoyed nearly the same level of commitment and enthusiasm as the rallies of the "bubble" years of the late 1990s and early-to-mid 2000s. As the Washington Post underscored in a recent article, most middle class Americans aren't invested in stocks at all. Among those who are invested, bullish sentiment is under 40% as of Oct. 26, according to the American Association of Individual Investors (AAII). This means that most active investors aren't terribly enthused over the stock market's intermediate-term prospects.

Moreover, since its pre-recession peak in 2007, the S&P 500 is up at an annualized rate of just 5%. As Scott Grannis points out, this is well under S&P's long-term average of just over 6% per year and well under the extraordinary rate of the last true melt-up in the boom years of the 1990s and immediately prior to the 2008 credit crash. So for all the hoopla about the stock market being in melt-up mode, the evidence actually points to the contrary.

What will it take then to confirm that a true melt-up is actually underway? The following list includes a few of the signs investors should watch for in the coming weeks and months in the event that the bull market enters melt-up mode. Admittedly some of these signs are anecdotal, but they've been reliable guides in every major market blow-up (and subsequent melt-down) in years past.

1. AAII investor sentiment should rise to well above 50% and remain above this level for more than a couple of weeks - a feat that hasn't occurred in several years.
2. Equity mania should be in evidence everywhere. Non-financial news magazines will make increasing stock market references. Media that don't normally provide market coverage will start making Dow references. Images of the bull will also appear with increasing frequency on magazine covers.
3. There should be a strong focus on a specific industry and not just on the market itself (à la the Internet stocks of the 1990s) which serves as a channel and conduit of investors' unleashed animal spirits.
4. Even if you completely unplug yourself from the market, you won't be able to avoid hearing about it. Stocks will become a ubiquitous topic of conversation in nearly every social situation of everyday life.

Currently none of these signs are in evidence, which strongly hints that a melt-up is not now underway. A melt-up may indeed happen in the coming year but not without conforming to all, or most, of the above mentioned signs. For now, investors are safe in assuming that the intermediate-term (3-9 month) trend remains on a strong footing with no danger of a melt-down.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.