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Barrons / Biz - Money

Rally Kicks Into Dangerous Overdrive

As tax reform gets closer, the stock market melts up. It won’t last.
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The stock market was usually strong after the Thanksgiving holiday, and now the specter of sweeping tax reform has pushed that to the extreme. Indeed, the term “melt-up” is in play as investors seemingly stampede into the already sky-high stock market.

The problem with melt-ups is that they can mark the end of the road for the bulls.

To be sure, I am not calling a top in the market right now. However, when sentiment leans too bullish and prices move at an unsustainably fast clip, bad things can happen.

Forget the politics. Forget the fundamentals. What we see now in the stock market is a stretched trend, overbought conditions in several time frames, and sentiment that is a bit frothy. We also see the market’s big technology leaders already pulling back.

Even so, the banking sector has scored a healthy technical breakout, small-caps in the Russell 2000 are in good shape, and even the beleaguered retail sector has seen some awakenings.

The point is that the broader stock market seems a bit too strong right now, suggesting that whatever comes out of Washington on tax reform—positive or negative—could spark a “sell the news” event.

Again, there really is no credible sign that this action is the end of the bull market. But when the long-term chart of the Standard & Poor’s 500 index shows the current short-term trend piercing the top of a long-term channel, we need to take notice (see Chart 1).

A channel is simply a trendline with a companion parallel line drawn to contain the action over time. Just before Thanksgiving, I offered a chart here with a channel containing the entire bull run from the 2009 bottom. At the time, I argued that there were new tailwinds in play to keep the rally going.

The final line was: “If conditions deteriorate, the market will tell us and we will have to change our tune.”

Conditions have not deteriorated, other than the tech pullback. Market breadth reached a new high, according to the advance-decline. New 52-week highs still swamp new lows. And even arcane indicators such as the Bullish Percent Index are back at high levels.

But this is a change from two weeks ago, when the trend was strong yet sustainable. A melt-up is the opposite of deterioration—and it cannot last.

It does not mean you should run out and sell your portfolio. Critics will, of course, tell you there are no better places in which to hide. However, chasing this rally cannot be a good strategy, and that suggests taking a few chips the table. It couldn’t hurt to have a little cash on hand to buy whatever dip is ahead.

The thing about melt-ups is that they often result in an opposite reaction. I won’t say “meltdown,” because that suggests the trend is already falling. It is not. But no bull market is infallible, not even this one.

Getting Technical Mailbag: Send your questions on technical analysis to us at online.editors@barrons.com. We’ll cover as many as we can, but please remember that we cannot give investment advice.

Michael Kahn, a longtime columnist for Barrons.com, comments on technical analysis at www.twitter.com/mnkahn. A former Chief Technical Analyst for BridgeNews and former director for the Market Technicians Association, Kahn has written three books about technical analysis.

Comments?E-mail us at online.editors@barrons.com

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