The Risks And Rewards Of Trading Around All-Time Highs In The Stock Market

Summary

The S&P 500 has been locked into a pattern of marginal all-time highs followed by notable pullbacks.

The percentage of stocks trading above their respective 40-day moving averages provides a convenient indicator for assessing the risks and rewards of trading around this juncture.

Until this indicator flashes red, the path of least resistance is upward.

A potential rotation from low volatility to high beta stocks in the S&P 500 and the VIX could fuel the next push to all-time highs for the S&P 500.

Seasonal performance looms as a salient risk.

Marginal All-Time Highs

After the S&P 500 (SPY) climaxed in January 2018 following a breathless 2017 run-up, the index printed three more periods of all-time highs. The gains on the maximum all-time high in each of those periods never exceeded 3%. Here are the maximum gains for each of the three periods over the last all-time high:

  1. September 20, 2018: +2.0%
  2. April 30, 2019: +0.5%
  3. July 26, 2019: +2.7%

The subsequent risks for achieving these new marginal all-time highs are pullbacks that cool off the buying euphoria. Here are the maximum (closing) drawdowns following the last four all-time highs, starting with the 2018 climax:

  1. January 26, 2018 to March 28, 2018: -9.3%
  2. September 20, 2018 to December 24, 2018: -19.8%
  3. April 30, 2019 to June 3, 2019: -6.8%
  4. July 26, 2019 to August 14, 2019: -5.9%

With these kinds of drawdowns, traders have an attractive incentive for assessing signals of exhaustion after all-time highs and/or conversely buying into the extremes of sell-offs. Since the market is currently pushing toward the upside extreme of a new marginal all-time high, I focus here on the case for the upside bias and an eventual topping signal.

The Reward of the Breakout

After spending a month in a clear trading range, the S&P 500 (SPY) broke out above its 50-day moving average (DMA) last week. While buyers have yet to confirm that breakout with a follow-on day of a notable gain, the short-term bias in the market is pointed upward. Unless the S&P 500 quickly turns around to dip back into the previous trading range, I expect the index to repeat its 2019 behavior of printing fresh all-time highs marginally higher than the last round of all-time highs.

The S&P 500 (<span>SPY</span>)

Above the 40-DMA

I use the percentage of stocks trading above their 40-DMAs to designate oversold and overbought thresholds, 20% and 70% respectively. These levels represent selling and buying extremes in the stock market. I call this indicator AT40 for convenience for "Above the 40-DMA" (this label is my way of renaming the cryptic term T2108, a technical indicator from Worden). When AT40 drops below 20%, my short- to long-term bias swings to buying the market. When AT40 punches upward through 70%, my bias swings to selling the market primarily after AT40 drops below 70% again. In this era of accommodative monetary policy, the stock market can experience extended periods of overbought trading conditions. In fact, depending on other technical conditions, an overbought period can provide a fresh buying signal for the stock market.

If AT40 trades up to, but not through, 70%, I might also turn my bias toward shorting/selling, as the failure to get to overbought represents one form of buying exhaustion. In 2019, mild exhaustion happened in March. April's exhaustion was more dramatic and preceded the big sell-off in May. July delivered a more direct challenge and failure of the overbought threshold that ushered in the sell-off and churn of August. The chart below demonstrates the dynamics. Note carefully how an initial dip through the overbought threshold in January provided a false, but brief, selling signal.The ability of AT40 to regain overbought status was a clear signal that buying power was not yet exhausted. AT40's subsequent approach to 90% was an extreme of historic proportions that confirmed the dominance of buyers and bulls.

AT40 ("Above the 40" or T2108)

Bullish Divergence

AT40 soared almost 9 percentage points on Monday (September 9, 2019) to close at 58.4%. This surge occurred even as the S&P 500 closed flat. This divergence is bullish, as it reveals buying strength percolating underneath the placid surface of the S&P 500. A confirmation of this bullish divergence should next push AT40 to or through its overbought threshold. Around the same time, the S&P 500 should print its next set of marginal all-time highs.

The Rewarding Signal from the Currency Market

The signal from the currency market currently supports the upside bias of the market. The Australian dollar (FXA) versus the Japanese yen (FXY), or AUD/JPY, has recovered sharply from levels last seen in April 2009, in the immediate wake of the financial crisis. Those lows coincided with the last pullback in August for the S&P 500. The subsequent bounce has taken AUD/JPY all the way back to where it traded during the big August 1 drawdown. I watch AUD/JPY because it typically leads or confirms the directional bias of the S&P 500, especially around extreme moves.

The Australian dollar versus the Japanese Yen (AUD/JPY)

This 50-DMA breakout suggests AUD/JPY still has room to run to the upside, which in turn supports a short-term optimistic outlook for the S&P 500.

Rotate! Low Volatility Stocks Versus High Beta Stocks

The split between the S&P 500's low volatility and high beta stocks suggests a bullish rotation of money may be underway. The Invesco S&P 500 Low Volatility ETF (SPLV) already made a new all-time high last week, while SPHB is just now breaking out from the trading range which mirrors the S&P 500 as a whole. I took note of the divergence of the SPLV versus SPHB today, with SPHB gaining 1.1% and SPLV losing 0.7%. Bargain hunting in SPHB could provide the fuel that provides the final push to get the S&P 500 over the all-time high hurdle.

Invesco S&P 500 Low Volatility Portfolio ETF (NYSEARCA:<a href='https://seekingalpha.com/symbol/SPLV' title='Invesco S&P 500 Low Volatility ETF'>SPLV</a>)

Invesco S&P 500 High Beta Portfolio ETF (NYSEARCA:<a href='https://seekingalpha.com/symbol/SPHB' title='Invesco Exchange-Traded Fund Trust II - Invesco S&P 500 High Beta ETF'>SPHB</a>)

The Volatility Index

The volatility index (VIX) still hangs in the balance. The VIX is just below what I call the 15.35 pivot. It tends to swing around this line when it is directionless. Given the other indicators, I will assume that a further implosion in volatility will support the short-term upward bias for the market.

The volatility index (VIX)

(Source for all charts: FreeStockCharts.com)

The Risk of the September Drawdown

Every bullish narrative should come with caveats.

The road to the next all-time highs could still be bumpy. After all, the S&P 500's worst months in terms of average maximum drawdown are August through October. Historically (since 1950), September experiences an average maximum drawdown of 2.8% (the median maximum drawdown is not remarkable relative to other months of the year). The month started with a 0.7% drawdown, but buyers took over from there. So, presumably, September still has some selling left to do. In other words, there is a collision of forces between the upside bias and the historical tendencies of the month. Perhaps September's selling pressure could remain "pent up" until October, which has an even worse history than September for maximum drawdowns; that perspective is the optimistic way of interpreting the data.

If the S&P 500 turns around and dips below its 50-DMA again, then I will assume the stock market short-circuited the short-term optimistic scenario of a new all-time high. A typical September drawdown should unfold from there.

Altogether, my short-term bias is neutral on the stock market, but I have no interest in shorting the market until one of the above signals triggers: a dip below the 50-DMA or the AT40 topping signal from the overbought extreme.

The market environment is, of course, full of potential surprises which can change the technical outlook in a heartbeat: Presidential tweets, a governor of the Federal Reserve speaking about monetary policy, more trade war news, etc... Still, I suggest the above indicators, anchored by AT40, provide timely tools to interpret the market's interpretation of macro events, and thus provide a method for sorting through the risks and rewards of the next set of short-term trading opportunities.

Be careful out there!

Disclosure: I am/we are short AUD/JPY. 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.

Additional disclosure: I am also long AUD/USD (and using the short AUD/JPY as an umbrella hedge)