The stock market, by all appearances, has become a perpetual motion machine that won’t even let a controversial tax plan or a change atop of the Federal Reserve derail its momentum.

And what momentum it is. The Dow Jones Industrial Average rose 105 points, or 0.4%, to 23,539.19, last week, while the Standard & Poor’s 500 index advanced 0.3%, to 2587.84. The Nasdaq Composite gained 0.9%, to 6764.44. All three benchmarks closed at record highs.

We know the headlines have all been about the Republican tax plan—which may help some stocks and hurt others—and the appointment of Jerome Powell to replace Janet Yellen as Fed chair. But the real story is that the best-performing stocks keep dragging the major indexes higher, meaning that this truly is a momentum-driven market.

On the Street, momentum is the strategy of buying the market’s best-performing stocks and ignoring all the rest. It’s been a winner this year, as highfliers like Boeing (ticker: BA), HP (HPQ), and MasterCard (MA) have helped it outperform. The MSCI USA Momentum Index returned 33.9% through the end of October, outpacing the MSCI USA Index’s 17% return. That 16.9-point performance gap is the best for a full year since 1999, when momentum outperformed by 17.2 points.

“It’s been an amazing run of outperformance,” says Oppenheimer technical analyst Ari Wald.

But has the gap between the performances of the two indexes grown too big? MKM Partners technical analyst Jonathan Krinsky compared how big that gap is relative to its 200-day average, and found it’s at a level that often signals a peak in momentum. Sometimes it’s simply a pause—that was the case in 2005—but sometimes it can signal an impending peak, as it did in 2008. “Momentum names are stretched relative to the market,” Krinsky says. “But they can become more stretched.”

The question is how much more. Andrew Slimmon, a portfolio manager at Morgan Stanley Investment Management, notes we’re at that time of year when investors ride their winners and dump their losers for tax-loss purposes. And this year, the inclination to hold winners might be even stronger than in the past, thanks to the Republican’s tax-reform plan—and the off chance that capital-gains taxes—left untouched so far—head lower in the final version. “Momentum works at this point in the year,” Slimmon says. “And it’s accentuated by the change in tax policy.” That suggests at least another month of outperformance.

But that seasonal boost is followed by the so-called January Effect, the name given to the period when investors finally take profits in the market’s winners. It used to happen in January—hence the name—but has moved to mid-December as market participants responded to the anomaly by selling even earlier. This year, it happens to coincide with Congress’ holiday recess, but also with the Federal Open Market Committee meeting on Dec. 12 and 13. Don’t be surprised if momentum hits a brick wall around that time. “We could see a reversal just as everyone wants to go on holiday,” Slimmon says.

But at least we’ll make merry until then.

(Source: Barrons Online)