How the market looks from a trading perspective … why a pullback is in the cards … but don’t count out the strength of this bullish move … why the long-term red flags are still there

Is it too late for you to get a piece of the recent tech gains?

Not if you’re ready to act like a trader.

As we’ve suggested in recent Digests, adopting a trader’s mindset is an effective way to navigate today’s complex market environment in which plenty of red flags exist, yet bulls remain firmly in control.

A trading mindset is helpful because it changes how you view stocks – basically, they’re just wealth-generating tools. If they’re effective at making you money, they remain in your portfolio. When their effectiveness fades, you move on to a better tool, or take a breather on the sidelines.

Such a mindset can help alleviate the number-one anxiety many investors feel today, which we referenced a moment ago…

Am I too late to get in on the recent gains?

That’s because when you trade, your mindset shifts from “owning” stocks, to “renting” them for only as long as they serve your purpose. And when you rent, you can be nimble, taking advantage of bullish market conditions while they’re here, and moving on when they’re not.

So, what are the markets telling us about conditions today? 

Well, stocks are likely looking at a short-term pullback (which appears to have already started) followed by a return to bullishness.

Why the RSI charts say a short-term pullback is likely in the cards – at least for tech

The Relative Strength Index (RSI) is a momentum indicator that measures the extent to which an asset is overbought or oversold.

A reading over 70 suggests an asset is “overbought” (which brings increased odds of experiencing a mean-reversion pull back) while a reading below 30 means it’s “oversold” (which brings increased odds of a mean-reversion surge).

Now, these respective pullbacks and surges don’t always happen, but they occur with enough frequency to make the RSI indicator a very valuable trading tool. And right now, this tool is telling us that the tech trade has reached exhausted levels.

Below, we look at the Nasdaq 100 along with its RSI chart.

(We’re focusing on the Nasdaq 100 in this issue because tech has been “the trade” of 2023. The Dow has gone practically nowhere, and the S&P is up largely because of the outsized gains of Big Tech.)

We’ll begin with a 30,000-foot view that takes us back nearly two years. What you’ll see is that 2023’s bullishness, that’s resulted in a 38% surge (at its peak) has also ushered in the index’s most overbought conditions since November of 2021.

But those levels are now beginning to drop as the market loses altitude…

It goes without saying but look at what happened to the Nasdaq 100’s price back in 2021 in the wake of those extreme RSI levels.

While this elevated RSI level doesn’t guarantee such a meaningful market pullback, as traders, we play the probabilities. And today’s probabilities lean heavily in favor of a period of market weakness as this elevated RSI level normalizes.

We also see evidence of a stretched market when we look at the Nasdaq 100’s moving averages

A moving average (MA) is a line showing the average reading of some number of the prior days’ worth of market prices.

MAs can be important psychological lines-in-the-sand for traders as they help identify price trends for a stock (or an entire market). They can also serve as support or resistance points, impacting traders’ investment decisions.

Below, we look at the Nasdaq 100’s chart here in 2023, along with its 50-day MA. This 50-day MA is considered a shorter-term time measurement.

The first detail to notice is the growing spread between the 50-day MA and the price of the Nasdaq 100. It’s stretched far more than has been usual this year.

Below, we see “typical” spreads in green along with the recent outsized spread in red.

The next thing to notice is what happened to the Nasdaq 100’s price the last time there was this much distance between the price and the 50-day MA.

Finally, what about volume?

If the market surges or drops, one of the first questions to ask is “did it happen on heavy volume?” If not, then perhaps only a handful of traders are pushing the market in a way that’s not representative of how most investors feel.

But if volume is heavy, that means a great deal of market participants believe in that move – so, pay attention to it.

Below, we look at the Nasdaq 100’s chart once more. This time, we’ve added volume.

Notice that the market pullback that began last Friday kicked off with exceptionally strong volume. Yesterday, which was actually a bullish day as investors “bought the dip” after the market opened lower, came on much less volume.

As I write Wednesday, it’s early, but volume appears to be tracking higher on this selloff (this doesn’t show up in the chart below).

Taken together, these clues suggest the market has a high probability of pulling back in the coming days.

But that doesn’t mean we’re done with the bullishness.

First, fear of missing out (FOMO) is working its magic and cash is flooding back into the market

In recent days, I’ve chatted with a few friends who have remained staunchly bearish in recent months. But as the market continues rising, their bearishness is cracking.

Sitting on the sidelines as other investors rack up huge returns is painful…and a very effective way of luring even more money into the market, which pushes asset prices even higher…turning more bears into begrudging bulls…which increases market gains…rinse and repeat.

Let’s jump to Bloomberg last week:

Confidence in this year’s US stock-market rebound continues to build, with money-market funds notching their first outflows in almost two months…

For contrarian traders betting against equity bears, that massive cash pile could keep the bull-market rally chugging along.

The amount parked at US money-market funds dropped by the most since mid-April, with total assets falling by $4.7 billion to $5.45 trillion for the week ended Wednesday, according to data from the Investment Company Institute. Funds had hit a record high of $5.45 trillion earlier in June…

If this mountain of cash begins flooding back into the market, it will be an enormous tailwind for additional gains.

So, will we see this money moving back into the market?

Well, in the same way that an over-stretched RSI level usually mean-reverts in the other direction, that’s often the case with over-stretched cash levels.

Bloomberg just noted that the cash in money market funds hit a record high earlier in June. While that level could certainly increase, from a probability perspective, mean-reversion suggests “cash moving into stocks” is more likely than “stocks moving into cash, pushing those cash levels to even higher records.”

Finally, the market’s trendlines reveal a powerful bullish surge

Below, we look at the Nasdaq 100 with its 50-day, 100-day, and 200-day moving averages (in solid blue, solid red, and solid green, respectively).

We’ve also added a trendline of its performance on the year (in dotted blue).

First, the chart, then we’ll add commentary.

Though the chart is a bit busy, there’s really only one thing you need to see…

Everything is up.

From the slope of the shorter-term 50-day MA… to the slope of the long-term 200-day MA… to the year-long trend-line…

There is nothing on this chart that hints at meaningful, long-term weakness.

Now, as we covered in the first half of today’s Digest, there’s plenty of data suggesting we’re standing at the edge of short-term weakness. But viewed in light of this broader bullishness, such weakness might be better interpreted as “wait for a better entry-point price” rather than “avoid the start of a massive market selloff.”

With respect to the market red flags…

Regular Digest readers know that I’ve skewed bearish for months.

That hasn’t changed.

I’m still concerned about toxicity in the commercial real estate sector, and by extension, fallout in regional banks… I’m wary about the health of the U.S. consumer who is rapidly running out of pandemic savings and turning to credit cards to fund day-to-day living expenses… I fear that certain stocks and sectors have eyewatering valuations that will, unquestionably, lose investors money in the long-term if bought at these levels… and I’m afraid that Wall Street bulls are banking too heavily on the Fed cutting rates later this year, in effect, interpreting the Fed’s Dot Plot as a bluff.

On that latest note, this morning, Federal Reserve Chairman reiterated his hawkish stance when speaking before the House Financial Services Committee.

From Powell:

Nearly all FOMC participants expect that it will be appropriate to raise interest rates somewhat further by the end of the year.

Pretty hawkish.

But…

These are all longer-term market influences. In the shorter-term, bullishness rules the day.

So, when your short-term and long-term market views contradict, you have a few main options…

Sell… do nothing…or trade the market.

With bullishness being the dominant market driver today, I vote we trade.

So, pulling it all together, watch out for short-term market weakness as overbought market conditions begin to normalize… medium-term, use weakness to look for strategic entry-points for strong, surging stocks… long-term, keep aware of the red flags that haven’t gone anywhere, and be ready to jump ship if/when the day of reckoning comes.

We’ll keep you updated,

Jeff Remsburg