Despite exuberance, continued signs of long-term recovery

The biggest challenge with this market, one we haven't really ever had to deal with before, is the conflict between an impressive recovery from a historic selloff, superimposed against a backdrop of record levels of speculative activity.

Recoveries from a bear market typically take much longer. By the time they've recovered and been at new highs for a while, speculation comes in, markets plateau, divergences form, and sentiment cycles back down during a correction.

If we look at a typical Sentiment Cycle, then we basically went from enthusiasm to panic and right back to enthusiasm, all in record time.

There is little arguing that we're in this part of the cycle. As the Knowledge Base article, "How do I use sentiment?" points out, this part of the cycle is identified by:

• High optimism - CHECK
• Easy credit (too easy, with loose terms) - CHECK
• A rush of initial and secondary offerings - CHECK
• Risky stocks outperforming - CHECK
• Stretched valuations - CHECK

All boxes are checked there. More objectively, when we look at the correlation between the S&P 500's price path lately versus the Enthusiasm phase of past cycles, there is a high positive correlation.

So, investor behavior is like we see near the end, but markets are showing the signs we typically see during the beginning stages of a long-term recovery with thrusts in breadth and the percentage of securities hitting 52-week highs. It's very strange, so we're still in the upper left-hand box of the Sentiment vs Market Environment matrix.

Among the signs of recovery, not just in the U.S. but worldwide, is that for the first time in more than 200 days, fewer than 20% of major world equity indexes are in corrections.

This ends one of the longer streaks since 1971 when more than 20% of countries had been in a correction at the same time.

After other streaks ended, it was a good longer-term sign for world stocks. The MSCI World Index showed a positive return over the next 6 months every time, and over the next 9-12 months all but once. Losses were minimal, and the risk/reward was excellent.

It was good for the S&P 500, too.

Small-cap stocks were among the biggest beneficiaries of these synchronized recoveries.

As were value stocks, with a median return of more than 24% over the next year.

The persistent and broad-based recovery can also be seen in the percentage of securities on the NYSE that have been able to hold above their 200-day averages. This popped above 80% a couple of months ago and has stabilized enough so that an average day over the past 50 sessions has seen more than 80% of securities in an uptrend.

The Backtest Engine shows that when breadth has been this persistent, there were no medium- to long-term losses over the past 25 years, even if it did indicate potential shorter-term overbought conditions and weak returns up to a month later.

If we go back further and take a longer-term point of view, then this kind of persistent and broad-based thrust remains a remarkably positive development.

There is no good way to square the two primary conflicting aspects of where we are right now.

Sentiment is horrifically extreme and almost all signs are present, screaming at us that we're seeing the kinds of behavior that are almost solely and universally seen at medium-term peaks in stocks. And yet, the types of recoveries we've seen in breadth and momentum have an extremely consistent tendency to occur at the beginning stages of longer-term recoveries, with few historical losses over a 6-12 month time frame.

While breadth / momentum and sentiment often give conflicting signals, it's never been to this extreme of a degree. So far, momentum is clearly winning, and we'd continue to give that the benefit of the doubt unless we see more oddities pile up, with underlying divergences and internal deterioration. If and when those start to trigger, it would suggest a high probability of a medium-term correction to rid us of some of these signs of exuberance.