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)

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)