Quant Model Shows Rally in Stocks Is Approaching ‘Manic’ Level

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(Bloomberg) — An historic surge in US stocks has pushed equities to fresh highs, yet signs of overheating sentiment suggest that the rally may be entering a slower phase.

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The rebound from the March lows, fueled in part by hopes of easing tensions between the US and Iran and a surge in corporate earnings, has lifted investor sentiment toward what a quantitative model from Bloomberg Intelligence strategists suggests is “manic” territory. The model tracks six components, and three of them have driven it toward that level: high-yield corporate bond spreads, low volatility, and pairwise correlations.

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That doesn’t necessarily mean a crash is coming: The backdrop has typically coincided with further gains, albeit at a more modest rate. From 2012 through 2023, the Russell 3000 Index delivered an average return of 2.9% in the three months following repeated elevated sentiment readings, according to BI’s Market Pulse model. During those periods, large-cap stocks tended to outperform, with the S&P 500 beating the small-cap Russell 2000 by about 178 basis points.

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Still, the current episode stands apart from past surges. Historically, outsized monthly gains of this magnitude have tended to follow deep market drawdowns, such as in April 2009 and April 2020, when equities rebounded from crisis-driven lows. This time, stocks rallied to record highs from an already elevated base, a dynamic that could limit future upside.

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“When everything works at once — growth over value, cyclicals over defensives — it’s usually a late-stage tell, not a fresh start,” BI’s Christopher Cain and Nathaniel Welnhofer wrote. “History says returns can still be positive, just less rewarding, with leadership narrowing back to large caps.”

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The S&P 500 climbed more than 10% in April, marking its fifth-best monthly performance in the past 35 years and pushing the benchmark to fresh all-time highs. It’s already tacked on another 2.2% less than a week into May. Futures on the S&P 500 traded 0.1% higher at 7:32 a.m. in New York. 

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The rally has not been without fundamental underpinnings, even as surging energy prices cloud the outlook for the rest of the year. First-quarter earnings are on track to grow almost 27% from a year earlier, more than double the 12.4% forecast heading into the reporting season. More than 83% of companies have beaten estimates as of Wednesday’s close, the strongest showing since 2021, while negative surprises are near their lowest level in over three decades, according to Bloomberg Intelligence. 

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Still, market breadth remains narrow as the recent leg higher was mainly driven by the biggest tech stocks. Only about half of S&P 500 members are trading above their 50-day moving average. Meanwhile, the Philadelphia semiconductor index is hovering at the most overbought reading since the Internet bubble.