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Indices: is there more to come?

After a gain of almost 20% for the S&P 500 and a general rebound across equity markets, is there more fuel for a continued bounce?

The state of equity markets at the end of January looked very different to just a month earlier. From 26 December, when the UK was still enjoying Boxing Day, a sustained rally in equities has taken place. Indices have still to recoup all the ground lost in the fourth quarter (Q4), but it has been an impressive bounce back.

But is there more to come? Or has this been driven by a combination of a newly dovish Federal Reserve (Fed), an earnings season that has been better than feared and a lack of bad news on the US-China trade war? Are we due further declines, with a sustained bear market ahead of us?

At first glance, the surge in equity markets since Christmas looks like a classic ‘bear market rally’. As I pointed out just before Christmas, bear markets do not usually go straight down. They see impressive rebounds before new legs down. So in one sense we are still in a difficult period for equities.

But while the slump of Q4 2018 might look like the beginning of the next 2008, markets have witnessed similar events before. Fears of a recession are on the rise, but the US is not yet in a sustained period of negative growth. The composite purchasing managers index (PMI), which tracks activity across the manufacturing and services sectors, remains in expansion territory, as it has done over the past five years.

When the benchmark S&P 500 suffers a drop similar to what we saw in Q4, but in a non-recessionary environment, the average return over the next year is 32%. In a recessionary environment, it falls another 3%. While no one year in the stock market is exactly like another, we do at least have a guide for what has happened in similar incidences before.

Assuming, for the sake of argument, that the next long bear market is not just round the corner (or, indeed, already here), are we likely to keep pressing higher?

For that, we can use market internals such as breadth to monitor the current state of affairs. Breadth looks at the number of stocks rising versus those falling, or the percentage of stocks in an index above key moving averages.

The first port of call is the indicator called the New York Advance Decline line (or NYAD for short). This is an indicator that takes the number of stocks going up and subtracts the number going down. It creates a noisy chart. But in its cumulative form it provides a very useful chart. When NYAD is above its 50-day simple moving average (SMA), then the market tends to continue to rise. When it falls below, i.e. showing more stocks are going down than up over the medium term, then the market either falls or becomes choppy. Below is NYAD with a 50-day SMA included:

We can see that NYAD fell below the 50-day SMA at the end of September last year. It took a few days for the S&P 500 to begin to fall, much like a cartoon character running over a cliff, but the index then began the sustained drop that only ended (at least temporarily) on 26 December.

Since then, NYAD has recovered impressively, even more impressively than the rebound on the S&P 500 itself. And while the index has yet to regain the highs of October and November, although it is heading that way fast, NYAD has already surpassed its peak from November. This ‘positive divergence’, when an indicator outperforms the price of the index, is usually a strong sign, and suggests more gains are ahead for the S&P 500.

The other indicator to use is the percentage of stocks in the S&P 500 above their 200-day SMA. The 200-day SMA is regarded as a useful benchmark of whether a price is in an uptrend or a downtrend.

As the below chart shows, the percentage of stocks in the S&P 500 above their 200-day SMA hit its lowest level in over three years at the end of 2018, falling to three standard deviations from the mean. This is a contrarian signal, it suggests a rebound is close at hand.

In a rising market, the percentage of stocks above their 200-day SMA tends to remain above the mean for an extended period, with some dips. The 2016-2017 period, and the middle of 2018, are good examples of this. At present the indicator is still around one standard deviation below the mean. It is now around the levels at which the equity bounces of October and November 2018 ran out of steam. If it can get back to the mean and keep moving higher, equities should continue to gain.

Nothing is certain, and a resumption in trade wars, or another such unexpected event, might well send markets on a downward path again. But at present, the data and previous instances of sudden drops in non-recessionary environments point towards the continuation of this rally. There will be dips along the way, but the great bull market that began in 2013 seems to have survived another panic.

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.

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