For the last three months, titans like Amazon.com, Alphabet, and Facebook have quietly lagged the market as investors bet on old-economy stocks like General Motors, Michael Kors Holdings, and Bank of America, all of which had double-digit gains during the same period.

Then last Friday happened. Stellar earnings from Amazon (ticker: AMZN), Alphabet (GOOGL), and Microsoft (MSFT) sent those stocks up 13%, 4.3%, and 6.4%, respectively. And just like that, tech is hot again. How hot? The Nasdaq Composite gained 2.2% on Friday, 2.06 percentage points more than the Dow Jones Industrial Average’s 0.14% advance, the widest single-day gap between the two benchmarks since 2002. The Standard & Poor’s 500 index rose 0.81% to 2581.07. Both the Nasdaq and the S&P 500 closed the week at new all-time highs.

The question is whether investors will wake up next week with a big tech hangover. Much will depend on earnings from Facebook (FB), which is set to report on Wednesday, and Apple (AAPL), scheduled for Thursday. But the situation isn’t all that different from tech’s June underperformance—the Nasdaq declined 0.9% that month–which was followed by a July rally, says Frank Cappelleri, a technical analyst at Nomura Instinet. And if financials, which have gained 3.5% in October, continue to rally, even after dipping 0.2% on Friday, you could have a recipe for an accelerating market with tech in the mix. “If people want melt-up potential, that narrative has a good chance of creating it,” Cappelleri says.

Unless one has already occurred. That’s a theory floated by INTL FCStone Financial strategist Vincent Deluard—based on the market’s low volatility. The Dow has returned 32% during the past 12 months, a great return, though there have been better. But the Dow’s realized volatility during that period has been around 7%, which would put its Sharpe ratio—a measure of an asset’s return relative to its volatility—at around 4.6. To put that in context, Deluard notes that in normal times, any hedge fund would be happy to deliver a Sharpe ratio that’s half of that. Another way to look at it is to consider what the Dow would have to return to maintain that Sharpe ratio if volatility returned to its average of 16% going back to 1900. The answer: More than 70%. “By any standard, a melt-up has already happened,” Deluard says.

And it is strange how quiet the market is. October, remember, is supposed to be the market’s most volatile month. Through Thursday, however, it was the least volatile October on record going back to 1928, according to Ben Bowler, global head of equity derivatives research at Bank of America Merrill Lynch. He chalks that up to the fact that the market assumes that the world’s central banks will backstop it no matter what, making every drop a buying opportunity. Bowler foresees two factors that might change that outlook in the U.S. One would be higher inflation, which could force the Federal Reserve to take a more hawkish stance. The second would be a new Fed chief—and that chairman’s outlook on the moral hazard created by central bank puts. “We need to break this psychology that shocks are good because it means an opportunity to buy the dip again,” Bowler says.

If tech stocks keep running, that might be easier said than done.

(Source: Barrons Online)