For stocks to continue hitting new highs, they need to pull back first

Posted by jbrumley on January 9, 2018 9:05 AM

By Matt Maley, CNBC

What a start to the year.

The stock market posted one of its best weeks in over a year and all the major averages hit records.

However, let's be honest: those who are looking for this rally to continue nicely through the rest of the first quarter should be hoping for a pullback right here.

That's right — a pullback at this juncture would help the market digest its recent gains and work off stocks' overbought condition, which will actually give it a better chance of rallying further in the future.

After all, that's exactly what we're looking for. The stock market has become very, very overbought; the S&P 500's relative strength index has now moved above 85, and sentiment has become very, very bullish. So bullish, in fact, that it has now reached levels that are usually followed by short-term pullbacks.

Not only have we heard many bullish comments from pundits and billionaires alike, but the latest Daily Sentiment Index data show futures traders have become wildly bullish on the stock market.
Something else to chew on here is what truly drove last week's impressive price action. The credit seems to be going to the expected impact of tax cuts and the synchronized global expansion we are seeing. That's great, and probably true. But did things really improve that much last week?

Yes, we got some better-than-expected data last week (at least until the employment report on Friday) both domestically and overseas. Still, they were not shockingly high numbers, and we did not see significant moves in any other market.

Instead, consider this theory: the data were simply good enough to help the stock market rally a bit; but then the algorithms kicked in and took the market higher, which caused so-called performance fear to kick in for institutional investors who don't want to fall behind at the very start of the year. That, in turn, took the market higher and in turn pushed algorithms to buy more, and these two issues kept feeding on one another.

Of course, this does not mean the market cannot go much higher over time; it could even go higher within a couple of weeks. We simply already knew the economy was growing on a synchronized basis, and the tax bill was passed before the holidays. Thus, we question whether last week's rally is something that will see a lot of upside follow-through in the near term.

Ultimately, our call in the very short term is the expectation of a stock market pullback this week. Once these broad indexes work off their overbought conditions, we'll want to see more solid earnings and how exactly companies will implement tax breaks. Then, we'll have a better idea of whether today's valuations are indeed justified.

Until we hear something about this global synchronized growth and the implications from the tax bill that are not already known, a pullback here would be healthy, and normal.