Is This Year’s Rebound In Global Markets Overbought?

How do you define irrational exuberance? There’s no single answer, much less one that offers flawless signals for timing rallies and corrections in financial markets. But judging by the latest trend data for all the major asset classes (based on proxies via a set of exchange-traded funds) suggests that this year’s rally may be overextended for strategies that are globally diversified.

The source for the analysis is a simple methodology for calculating the trend (based on moving averages) for each of the ETF proxies and then aggregating the results in a diffusion index. For defining the trend we’ll crunch the numbers on two fronts. The first definition compares the 10-day moving with the 50-day average, providing a profile of short-term trending behavior. A second set of moving averages (50 and 200 days) offers an intermediate measure of the trend. The results are:

a) calculated for each of the 14 ETFs that comprise the major asset classes

b) summarized in a diffusion index, which ranges from 0 (all funds are trending down) to 1.0 (all funds are trending up).

For additional context, the chart below also shows the performance of an ETF-based version of the Global Markets Index (GMI.F) — an investable, unmanaged benchmark that holds all the major asset classes (except cash) in market-value weights.

The main takeaway: most, arguably all corners of the global markets are exhibiting a strong bullish bias (based on prices through Mar. 28). Reviewing the 10-day/50-day profile shows that a clean sweep of upside momentum (red line in chart above) prevails. The aggregate for the 50-day/200 measure isn’t all-in, at least not yet, but it’s close: roughly 86% of the ETFs are trending up by this measure (blue line).

Why should we care? Because when everything’s trending higher, it’s often a sign that there’s nowhere to go but down (or perhaps just sideways for a time). Let’s be clear: all markets can (and sometimes do) trend higher in unison for an extended period and so it’s never fully clear if a broad-based bull run is on its last legs or set to confound contrarians for the foreseeable future. But in pursuit of estimating the probability of where markets overall are headed in the near term, monitoring the diffusion indexes above (or something comparable) is a reasonable toolkit for quantifying the ebb and flow of bull/bear sentiment.

Unsurprisingly, when the diffusion indexes reach 1.0 (all the GMI.F funds are trending up), a correction in GMI.F tends to follow. On the flip side, when the diffusion indexes are at or near 0.0, the downside momentum has often run its course, laying the groundwork for a rebound.

Note that when extreme downside momentum is widespread (the diffusion indexes are at or near 0.0) during periods of elevated recession risk, the expected rebound may be delayed, perhaps for much longer than expected. But for the moment, it’s fair to say that US recession risk remains low.

As for the current climate, the two measures of trending behavior in the chart above strongly suggest that bullish sentiment is once again in the extreme. In turn, that implies that the odds appear elevated that headwinds are building for GMI.F (and other broadly diversified portfolio strategies).