The Tide is Turning

Thoughts on the Market

The past few trading sessions leave little doubt that momentum has shifted. Market breadth is firming, more groups are participating, and the leadership picture looks clearer than it has in weeks. With that in mind, it’s time to shift up a gear and take advantage of the improving conditions.

Looking at our go-to risk appetite gauges, and listening to the best risk sniffers in the market — credit investors — suggests this rebound is getting all the confirmation it needs. After a couple of bear traps, both risk-appetite ratios have moved sharply higher, and high-yield spreads are back to their tightest levels in over two months.

Interestingly, high-yield spreads — typically the more sensitive indicator — never exceeded their October 10 levels, which makes the recent widening in investment-grade spreads all the more notable. But in our view, there’s an important twist.

The key thing to keep in mind is that the big AI names are shifting from asset-light cash machines to asset-heavy capex beasts, taking on more debt to fund rapidly amortizing AI build-outs. That added leverage is forcing credit spreads to rerate accordingly.

Even so, the stability of high-yield spreads in recent weeks suggests this isn’t a genuinely risk-off market signal.

Now, Tech hasn’t exactly been leading the rebound off the lows, but it has been encouraging to see the sector steady itself right where it needs to against the S&P 500 ex-Tech Index.

If you remember the chart we shared three weeks ago, we pointed out that a drift back toward Tech’s long-term relative trendline — even with a little overshoot — is basically just your garden-variety pullback. It shakes out some of the excess and helps keep the market healthier.

The only time it gets worrisome is when we break more than a standard deviation below trend. So far, that hasn’t happened, which strongly suggests the weakness we’ve seen is simply a routine, overdue correction.

Our Proprietary Risk Model tells the same story. It never flashed anything resembling a warning. It’s pulled back a touch, but it’s still deep in risk-on territory.

For anyone new here: this model is the backbone of our Market Playbook. Since 2005, it’s basically captured all of the S&P 500’s net gains — while being invested only 62% of the time. In other words, our model zeroes in on the sweet spots — periods when risk-adjusted returns are unusually strong — while steering clear of those choppier, high-volatility stretches.

By now, it’s clear that a Zweig Breadth Thrust isn’t happening. But the historical forward returns from almost triggering one — and doing it in half the required time — still make a strong case for keeping risk exposure high. These setups are super rare and have averaged 32.6% over the next year, with every one finishing higher.

What remains alive are the odds of us seeing more than 55% of S&P 500 stocks making new 20-day highs — the required threshold to trigger a deGraaf Breadth Thrust. Last Friday we closed with 22%, so we’re basically one strong day away from potentially hitting that trigger.

All of this points to favorable conditions for risk takers, which is exactly why we said it’s time to shift up a gear. For us, that means leaning heavier into small-caps and pressing the bet.

We first recommended jumping into small-caps back on August 25, and we’ll admit we were expecting a much stronger momentum pop from this group. Still, given how every “buy small-caps now” call over the past few years has aged like milk, we can’t really complain about the Russell 2000 eking out a bit of outperformance vs the S&P 500 — with its maximum underperformance since then only slightly over 3% at one point.

At this point, it’s hard to ignore that the Russell 2000 is once again pressing against a key resistance level dating back to 2021. What’s especially notable this time is that the market is trying to clear out all remaining sellers with broad participation and the biggest surge in momentum we’ve seen in years. Just to put it in perspective, the Russell has jumped nearly 10% over the last 10 days.

Pressure is clearly building, and we’re watching a textbook setup unfold.