This Is What A Market Melt-Up Looks Like

This Melt-Up Has Legs

The stock market, despite a widespread and possibly worsening global recession, has been chugging steadily higher for weeks. If you are still wondering why it is because the market is melting up.

In its classic sense, a stock market melt-up is when the market is faced with a rapidly improving outlook, be it real or imaginary. The improvement in outlook causes a rapid revaluation of the market that in turn attracts new investors. The faster the market rises, the more investors feel the FOMO, the fear of missing out, and the inflow of capital caused by that drive the market even higher

“A stock market melt-up refers to a sharp improvement in the investment performance of the stock market that is driven purely by sentiment. It’s usually caused when investors are flooding into stocks because they notice that the market is rising rapidly and they don’t want to miss out … The rise in a stock market melt-up isn’t caused by actual fundamental improvements in the economy, but rather by hype and tons of new retail buyers coming into the market to profit on the rising trends.”

The big risk with chasing markets in melt-up mode is that gains are not often grounded in reality. With no fundamentals to support them, index prices are subject to correction. The factors that set our current S&P 500 (SPY) melt-up apart are that the economic outlook actually is improving and it’s happening in tandem with a very strong trend-following signal.

Three Reasons To Expect A New S&P 500 All-Time High

The Sleeper Must Awaken

There is no doubt the global coronavirus pandemic has put a real hurting on the economy. What we need to remember is that, before the pandemic struck, the U.S. economy was strong. Very strong to the point of robustness. The outlook for the first-quarter GDP was on track to top 2.0% and showed signs of accelerating toward the 3.0% range by mid-year. The most notable improvements in data were in the labor markets which showed tight conditions, high demand, record levels of employee confidence, and record low unemployment.

When the pandemic struck and we went into lockdown no one really knew how long it would last but one thing everyone agreed upon was its temporary nature. Businesses didn’t just shutter their doors and throw in the towel, they prepared to weather a storm with the intention of coming out the other side. What I’m trying to say is this, the economy didn’t disappear it went to sleep, and sooner or later the sleeper will awaken. Based on the May NFP report it looks like this giant is already waking up.

Correcting An Overcorrection

When the market melted down in February and March of this year it was because of a rapidly deteriorating outlook. The worse the outlook got the further the market fell and, quite frankly, the very worst possible outcomes were what got priced in. When the selling started panic took over and everything got sold in the rush to preserve capital. What actually happened, regarding the pandemic, was much milder than what was forecast (I remember the WHO predicting something like 10 million dead Americans). This means the market, when it hit bottom, was over-corrected and in need of a rebound.

The question at that point was how high can/should the market go? With each step higher the market got a new piece of news be it declining COVID counts, word on vaccines/treatments, economic stimulus, and signs of resilience as economies began to reopen. Now, nearly four months after the correction began, the S&P 500 is on the brink of recovering all of its losses with an outlook that continues to improve.

A Secular Trend-Following Signal

If there is one signal in the market that all traders know and love it is a good, clear trend-following signal. The stronger the trend, the stronger the signal, and the trend I want to talk about is the secular trend. The secular, or primary trend, is a measure of the underlying fundamental condition of the market and that condition, for us, is bullish.

To fully appreciate what I am talking about we need to look at the chart of monthly prices for the SPX. The index has been in and still is in an uptrend since early 2009. The pandemic correction may have technically caused a “bear market” but what it did not due was break the trend. In fact, price action fell right down to the trend line where it hit support, bounce strongly, and created a trend-following entry signal.

At this time there is no reason, no technical reason, to expect the market to fall before it retests the all-time high There are some fundamental drivers that cause some concern but the number one, valuation, is mitigated by the reopening. At today’s prices, the S&P 500 is trading over 21X its forward earnings and at a multi-decade high. At this valuation it is wise to prepare for the market to correct but, with the reopening underway, it is also wise to expect the analysts to begin raising their EPS estimates for the second half. When the analysts begin to raise their estimates a new all-time high will be all but assured (if it hasn’t already happened).