What a run it has been!  The S&P is up better than 20% and the tech-laden NASDAQ is up better than 45% year to data.  Label it as either a new bull market or a bear market rally, it has been strong.

The stock market seems poised to challenge old highs based on good technical action and the widely held expectation that a recession has been averted and the FED has pulled off the magical “soft landing.”  And bulls will rightly point out there is still significant cash on the sidelines.

For the bearish naysayers, the last few months have been difficult.  Just since the middle of March, the broad market is up 22%.  To be sure, the breadth has been narrow with the “magnificent seven” accounting for the bulk of the gains.  Historically this is not healthy although of late breadth has expanded somewhat from earlier extreme concentration in all things tech.  This has given the bulls even greater confidence.

Likewise, the signs of economic strength have emboldened investors. There is diminishing fear of recession in the US, although much of Europe and China looks alarmingly soft.

Have tried and true indicators of a recession been proven false this time, or have they simply not had enough time to work?

Our biggest concern for the short term is that public psychology tends to push to extremes, one way or the other, much like a pendulum.  Because of that readings in sentiment tend to be the most helpful at extremes.

As we previously noted, markets can get overbought and stay overbought for some time, so we are making more a statement of the market’s condition than a statement of timing.  It would appear we have been in that overbought condition since early June.  Price has continued to advance even within the overbought condition.

However, we are beginning to see telltale signs of fatigue.  This is showing up in momentum data and sentiment studies.

Nevertheless, we are in some kind of large bullish equity move, regardless of the labels you wish may wish to use.  But it is looking a bit tired and we have now registered some extreme readings.

For those older or those who wish to limit their risk, this may be a good time to take some profit, write calls, think of using a crawling stop, and check your asset allocation.

Most of what we will likely experience will be a correction within a “bull” move that will work off some of the current excesses in the market.  As we approach all-time highs, it could be more serious than that. Right now, it is too early to tell. At present,  it looks more like the “pause that refreshes”, as the soda pop ad used to say.

The market has really surprised a number of people in its ability to buck the interest rate trend. We would put ourselves in that camp.  Markets can do well with higher rates, but markets historically are adversely influenced by a rapid change in rates, which we certainly have had.  But not this time.  It would seem that fiscal stimulus and recovery from the lockdown have overpowered many past indicators.  The market has plowed through all the noise of rising rates, recession threats, and inverted yield curves.

But rising rates are hurting the economy if not the market yet.  For example, delinquency rates on credit cards from small lenders are at an all-time high, the average US credit card balance is at $7,3000, a record high, suggesting people are borrowing just to live. US sovereign debt has been downgraded by Fitch, the 30-year mortgage is back over 7%, and according to the Kobeissi Letter, 20 states now have 40% of household income just going to house payments, and bankruptcies for the first half of the year exceed that of 2020, the year of the lockdown and the most since 2010.

The credit system is stressed, even if stocks are not paying attention.

However, both rising rates and inverted yield curves have lagging effects and they are not instantaneous. We don’t know yet that the skeptics are wrong, but we do know they have been early.  The market has powered through a very sharp increase in rates.  But in due time that can’t help but damage the economy.

The same can be said for the plunging money supply and contraction in bank lending.  It may take more time but that does not mean that in the end, it won’t be important.

Besides momentum being overbought and starting to stall, as we have noted the other concern is sky-high sentiment.

The argument is summarized as follows:  while it may have been correct for the vast majority to be bullish, once they are, and have taken action on their opinions, it is now all in the market price.  How much more at the margin can people get bullish?

Sentiment studies further break down into two areas.  There is survey data, which is more or less, asking investors their opinion, and there are action indicators, which allow us to see if that opinion is being translated into actual market positions.

But since people can have opinions and not act on them, we need that action sentiment to confirm.  Are people fully committed, are they using margin, do calls swamp the number of puts, are institutions fully committed?

Opinion survey sentiment is quite overbought.  Last week the spread between AAII bulls and bears reached 30%, one of the highest records ever.  The public is very bullish.

Sentiment action indicators are confirming the overbought condition. The National Association of Investment Managers indicates now an almost 100% allocation to stocks.  True, the number can get up to around 110 as managers go on margin, but usually anything around 100% is cause for concern.  Professionals are as bullish as the public and that is not a measure of opinion but one of action.  They have committed portfolio cash to equities to 100%, and can only go further by going on margin.  Just last October, when the market was a real steal, professionals had less than 20% allocated to equities.

What is the lesson from that?  Professionals can be just as emotional as the public.

Another good summary of action is also the CNN Fear and Greed gauge. On June 30th, the gauge hit 84% bullish, a reading of extreme greed. Just last March, on the eve of the big rally beginning, it was just 23%.  Notice the 80-20 principle seems at work here?

We are supposed to buy when prices are low and the public is bearish.  The old saying was “Buy snow shovels in July and straw hats in January”. But crowd behavior being what it is suggests the public does not have confidence unless confirmed by the actions of others.  Humans are herd animals.

Usually, once sentiment numbers begin to reverse, the market will follow in a few weeks.  Our readings suggest sentiment is beginning to weaken.  For example, the aforementioned CNN gauge hit 84%, putting it squarely in the “extreme greed” level but it has now dropped to 77%.  The reversal in sentiment is a key indicator to watch.

This brings to mind another famous dictum of Warren Buffet: ” Be fearful when others are greedy and greedy when others are fearful.”

How would you rate the current psychological state of the market?

Finally, the market has some patterns within the year that technical types refer to as seasonality. August tends to be one of the weaker months with September being the worst. This is a time when particularly in Europe, everyone goes on vacation and the market volume begins to dry up.  As such, the market tends to become more sensitive to adverse developments because the “collective mind” literally is at the beach or in the mountains.

Thus it would seem that overbought conditions in both momentum and sentiment have reached extremes just in time for August and September.