Stocks ripped higher off their April lows, enjoying some of the biggest (and fastest) gains I’ve seen in my four-decade career.
Last Thursday’s all-time highs in the S&P 500 and Nasdaq represented mammoth 32.9% and 42.8% gains, respectively, from the April 7 lows. Retail investors’ insatiable appetite to buy shares drove a big part of that rally.
However, the price action this past week suggests that their conviction to buy everything in sight may be reaching exhaustion.
Despite four of the Magnificent 7 stocks beating earnings expectations last week, both the S&P 500 and Nasdaq rolled over.
That might have surprised some, but it’s a common phenomenon in the market…
Excessive Valuations
With so much retail money pouring into the market, hedge funds and other big market players have learned to keep out of the way.
With access to markets just one click away, it’s easier than ever for folks to buy into Coinbase (COIN), Nvidia (NVDA), or any of the latest “meme” stocks.
Volume has a way of attracting volume, so to speak. The more money that flows into a stock, pushing it higher, the more other buyers will join the action.
The problem is that this rampant buying pushes valuations right out of whack.
Take NVDA, for example… It has gained more than $2 trillion of market capitalization in less than four months. With around 24 billion shares outstanding, a $10 move accounts for around $240 billion of market cap.
That’s more than the individual market caps of stocks like UnitedHealth (UNH), IBM (IBM), Salesforce (CRM), Caterpillar (CAT), Blackstone (BX), or even McDonald’s (MCD).
In fact, a $10 move in NVDA accounts for more market valuation than all but the top 37 stocks in the market.
As we’ve seen since April, retail investors can benefit enormously when momentum is heading the right way.
However, the market eventually runs out of buyers. And it can be disastrous when the bubble bursts and momentum sharply reverses…
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New Investors
It’s a movie I’ve seen plenty of times before…
When bubbles form, they keep pulling in new investors – often folks who haven’t been through previous market cycles.
When that bubble suddenly pops, it blows those same folks out of the markets. Some don’t return for years, if they return at all.
Eventually, the professional money retakes control of the market. Unsustainable stock valuations come back to Earth.
The trick to identifying when these reversals are about to unfold is to look for divergences in the market. It’s something I learned decades ago and was pivotal to me becoming a successful trader.
We’re not just looking for divergences between stock prices and crazy valuations. We’re also watching stock prices and buying momentum.
When those divergences become too extreme, it can set up some incredible trading opportunities when the market rebalances.
We may witness that again soon enough.
If you want to learn how you can generate outsized profits when that dramatic move unfolds, simply go here to watch the Market Divergence briefing I released yesterday.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
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