As 'Diversifiers' Fall Behind, We Can't Overlook a Glaring S&P Divergence

The major indexes are at all-time highs, but as I wrote last week, that hasn't helped those who've followed the traditional portfolio theory of diversification. An inevitable result is that investors start to fear missing out, and give up on their disciplined approach to chase momentum stocks higher. This is unfortunate, because buying stocks for no other reason than they are going up, and everyone else is too, is a dangerous game. 

Here, I'll offer some additional context, chart out a key diversification fund and point out a glaring divergence in the S&P 500.

In my last column, I mentioned that many well-diversified portfolios have yet to meet their 2021 high watermark and pointed out the Vanguard Target Dated 2030 Fund VTHRX, a textbook example of proper investment allocation. But I wanted to offer details of the fund’s holdings and a visual of its recent performance.

E-mini S&P 500 Monthly Chart

Due to changes in volatility, we have slightly updated our trendline support/resistance figures. Here is a refreshed chart depicting possible pivotal price points.

The most alarming revelation of our chartwork is the persistent divergence between the Relative Strength Index and the S&P 500. The early 2018 high achieved a monthly RSI reading of nearly 88. This was perhaps the highest overbought reading the RSI has ever produced for this asset. The S&P 500 peaked at the same time near 2880, a level that, if seen again in our lifetimes, would result in many grown men and women succumbing to tears. Yet, it was just six and a half years ago that 2880 was considered wildly overvalued for the S&P 500. 

Since then, the index has made significantly new highs, but the RSI has failed to match its 2018 high. In fact, the 2021 high, and thus far the current rally, has resulted in lower RSI highs. The divergence between price and the RSI has traditionally been a sign of imminent reversals for overextended markets; this has been true even of the more epic trends in various asset classes (think natural gas and copper rallies in 2022 and Treasury selling in 2023).

Government stimulus has enabled the equity market to trade well beyond its customary and reasonable trajectory. I’ve marked what I believe to be the historically average trading range projection with blue lines. Without the massive increase in money supply, we would likely be talking about an S&P 500 somewhere between 4,750 and 3,500. 

Nobody wants to hear this, but the only way to normalize the market is either through the passing of time (years, not weeks or months) or a correction of price; or it could be a little of both. Bluntly, if history is the guide, either the market needs to trade sideways for several years to let time catch up with price, or the index needs to shave off 1,000 or more points.

E-mini NASDAQ 100 Monthly Chart

Once again, the Nasdaq 100 is coming in too hot. The Nasdaq 100 spent a decade adding 7,000 points to its value after the financial crisis, but managed to put together a 10,000 rally in just 20 months on the heels of excessive Covid stimulus and easy money policies. 

The 2022-to-2023 correction eventually gave way to another parabolic-style rally. This time, we’ve seen an AI-driven rally pick up 10,500 Nasdaq 100 points in just 21 months to almost match the previous bull cycle. Can it continue? Sure, but it is unlikely to be sustainable. Like the S&P 500 chart, we see RSI divergence in the Nasdaq 100. This red flag can be waived for months before consequences arrive, but they always come.

This excerpt is from the last write-up, but it is worth repeating: 

I’m not an investment advisor; I’m just a futures and options broker. However, in my personal finances, I’ve been systematically de-risking as the market inches higher and have encouraged my brokerage clients to hedge their downside risk with risk reversals or similar strategies. Risk reversals involve selling a call option and using the proceeds to purchase a put option. In short, it is free insurance. The opportunity cost of using the market’s money to buy your portfolio insurance is giving up portfolio gains above the strike price of the short call option.

Protection should be bought when you can, not when you must. Volatility is historically low, and the indices are at all-time-highs. There has never been a better time to hedge; it is possible to purchase proximal insurance for far less than is normally the case. Today, an investor can hedge their equity risk by selling a December e-Mini S&P 500 6100 call for about 50 points and using the proceeds to purchase a 5100 put. This allows the portfolio to grow to the next trendline but takes the tail risk away under 5100. 

At the time of publication, Garner had no position in any security mentioned.