Caution: Potential Melt-Up Ahead

Market analysts often misinterpret the data they’re reading. That’s what seems to be happening in small-cap stocks, or stocks of smaller companies,

Road signs and market analysts always seem to be flashing caution signals.

I live in Colorado, and it’s not uncommon to see signs warning of icy roads ahead. When I drive near Denver, the signs warn of traffic ahead. And when I head north toward Wyoming, the signs are always flashing a high-wind warning. The truth is, if you are familiar with this part of the country, the signs aren’t telling you anything.

It’s Colorado. We get cold weather and snow. So there are probably icy roads in winter. Denver is a city, and traffic is common in cities. As for Wyoming, if you’ve ever been there, you know it’s windy.

In this way, road signs are a lot like a typical financial market analyst who is always stating the obvious. There is always the chance of a market decline ahead. It’s the most common advice I see about the markets … but here’s why it’s perfectly worthless information to most of us…

Like those road signs, the warnings might seem like a good idea since there are some people who aren’t aware of the situation. Unlike road warnings, market analysts often misinterpret the data they’re reading. That’s what seems to be happening in small-cap stocks, or stocks of smaller companies, as the chart below shows. Where many analysts see a sell signal, history tells us to expect a market rally.

 

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Market analysts often misinterpret the data they’re reading. That’s what seems to be happening in small-cap stocks, or stocks of smaller companies,

 

The iShares Russell 2000 Index (NYSE Arca: IWM) is an exchange-traded fund (ETF) tracking the benchmark index for small-cap stocks. The annual rate of change (ROC) indicator shown at the bottom of the chart just topped 40%. This means the ETF has gained 40% in the past 52 weeks.

The bears have a logical argument at this point — prices have gone up too fast, and this pace is unsustainable.

Not surprisingly, the conventional wisdom is wrong. The last time IWM’s ROC topped 40%, in November 2013, the ETF gained more than 9% in the next four months. An 18% rally in 10 weeks followed a 2010 buy signal.

Overall, testing shows that the market is more likely to go up in the months after ROC tops 40% than down. Historically, this is a rare but bullish short-term signal.

There have only been eight buy signals since 2000 when IWM began trading, and in six of those times (75%), the ETF was higher two months later. On average, IWM shows a two-month gain only 6.25% of the time.

All Aboard the Trump Rally Train

What the bears are missing is that the large move in prices reflects widespread interest in the stock market. Buyers are rushing in because they want to own stocks.

Most analysts think a stampede of buyers is bearish. They like to argue that when everyone is bullish, the market is due for a fall because it’s impossible for the majority of investors to be winners in the market.

The truth is, stocks go up when there are more buyers than sellers. For now, there is more interest in buying stocks because there is a widespread belief that President Donald Trump will deliver change. The Trump rally can be seen in the daily chart of IWM.

 

Market analysts often misinterpret the data they’re reading. That’s what seems to be happening in small-cap stocks, or stocks of smaller companies,

 

As the market rallied at the end of last year, individual investors added cash to money market funds. In other words, they missed the boat. Now, after two months of sideways action and a strong earnings season, individuals may feel like they can move money into stocks.

Knowing they missed a big gain last year, they are likely to invest aggressively, pushing small-cap stocks such as IWM up quickly.

Eventually, the move will run out of buyers, and then we may see that decline so many analysts expect. But nimble investors should consider preparing for the melt-up that so often precedes meltdowns in the market. We could be on the verge of a rapid upmove that will deliver large gains in a short amount of time — the kind of move no one wants to miss.

There will almost certainly be time to get out of the way of the decline if we watch the right indicators. Or we can follow the traditional signs and miss all of the potential gains by playing it safe. We know from the balances of money market funds that many investors have been doing that since the election.

Of course they are safe … a little poorer than they should be, but safe. And staying safe is the reason we have all those warning signs.

Regards,

Michael Carr, CMT