Tax cuts fueling the market melt-up, but signs show stocks are way ‘overbought’


How much more can we pack on to the markets? That’s the question the trading community is asking Thursday as we hit new highs in the S&P 500 for the sixth straight day … the longest streak of record closes since 1997.

Here’s the witch’s brew that has been powering stocks forward:

  1. Tax cuts: Tax reform prospects were the main driver of the market today, giving stocks extra room to run. Markets moved up late in the morning, when the House passed a budget resolution, which is the first step toward tax reform.
  2. Stronger economic numbers, including the September ISM Manufacturing Index (highest in 13 years) and Services (highest since 2005).
  3. The reflation trade, characterized by global economic expansion and higher yields.
  4. Sector rotation. In the past several weeks, small caps have outperformed, and value (banks, energy) have ticked up. Both were underperforming for a good part of the year.

As these elements have combined, the rally has become broader and more powerful. Thursday, the entire market was up: large caps, mid caps, small caps. Value as well as growth. High beta and low volatility. Only transports lagged. The one missing element is volume.

The main risks to the market are well known: North Korea, the appointment of a more hawkish Federal Reserve Chair (Kevin Warsh, etc.) and tax cuts failing.

But for the moment, the market is not afraid of any of these issues.

Regardless, what’s clear is stocks are very overbought. How overbought? The relative strength indicator (RSI), a widely watched momentum indicator of stock movements in the last several weeks, has the Russell 2000, industrials, financials and energy sectors all with an RSI over 90. That is WAY overbought. Readings below 40 are considered oversold, anything over 70 is overbought, and over 90? Well, you are in rare territory, and it indicates the market will likely slow down.

There are other gnawing worries, like, is the reflation trade a head fake? It happened earlier this year, when the markets moved down to sideways for several months, unsure which way growth was heading. It could happen again if global growth metrics falter.

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