Gapping After Optimism Hits An Extreme
In the Daily Reports and these Notes, we've focused on two major themes:
- The "gappy" nature of the market over the past couple of weeks has typically been a good medium-term sign of excessive uncertainty and buying demand.
- A market that continues to rally in the face of excessive short-term optimism almost always sees even further gains in the medium-term.
Both conditions are in force this morning, as stocks are indicated to gap up at least 0.5%, though that is off the earlier indicated gains. And the Short-Term Optimism Index closed above 80 on Thursday, a clear sign of excessive optimism.
Since 2000 there have been only 7 other days when the S&P gapped up at least 0.5% after the previous day's Optimism Index was above 80. Returns over the next two weeks were interesting.
Of the 7 occurrences, 5 of them occurred during the thrust off the bear market low in 2009. Outside of those instances in March 2009, the S&P struggled to maintain any further short-term gains. If we exclude those March dates, the S&P's maximum gain averaged only +2% versus a maximum loss of -5%.
So, once again, the idea is that stocks should decline, or at least plateau, from these conditions when looking out over the short-term of at least several days. But if it doesn't, then it should pay to be even more aggressive in the medium-term as the probability of further gains increases.