10-6-17 7:19 AM EDT | Email Article

By William Watts, MarketWatch

'Excessive credit and a timid Fed' set the stage, analyst says

Some market veterans think stocks are due for a meltup.

"We make the case that despite the Fed's intent, we're on the verge of being in a melt-up stage, fueled by excessive credit and a timid Fed," wrote technical analyst Jeff deGraaf, chairman of Renaissance Macro Research, in a Wednesday note.

Longtime market bull Jeffrey Saut, chief investment strategist at Raymond James, on Tuesday argued that the S&P 500 , in the wake of a Sept. 25 reversal to the upside, "now appears to be involved in a melt-up."

The S&P followed that turnaround with a series of fresh records. On Thursday, the S&P notched its sixth consecutive record close, its longest such streak since June 1997 (http://www.marketwatch.com/story/the-sp-500-just-posted-the-best-record-streak-in-20-years-as-stocks-dig-further-in-to-all-time-highs-2017-10-05). The Dow Jones Industrial and Nasdaq also ended at records

Dramatic and unexpected'

Saut pointed to the Investopedia definition (http://www.investopedia.com/terms/m/melt-up.asp) of a meltup as a "dramatic and unexpected" rise in the performance of an asset class driven in part by a stampede of investors who don't want to miss out on the rise rather than by improvements in fundamentals. Melt-ups are often followed by market drops.

Saut, who noted that Raymond James's short- and intermediate-term models had turned negative in early August, said the recent rally "was certainly unexpected by us."

It isn't so clear, however, whether the rally lacks improving fundamentals given stronger-than-expected economic data, including upgraded gross-domestic-product readings and the fastest manufacturing pace in 13 years, he said in a note.

And as of yet, there's little sign of a stampede. Total composite volume on Thursday was 5.81 billion shares versus a year-to-date average of 6.45 billion.

How melt-ups begin

Others have also attributed recent gains in part to revived optimism over potential corporate tax cuts as the White House and congressional Republicans revive a push for a wide-ranging tax bill.

Whether the market continues to melt up "remains to be seen, but what has happened since a week ago sure resembles how such melt ups begin," he wrote.

De Graaf, meanwhile, argued that it is the strong data, and what he sees as a behind-the-curve Fed, that is setting the stage for a potential meltup.

He fears that favorable credit conditions are driving asset inflation and points to the gap between the yield on the 2-year Treasury note , which is near a 10-year high at 1.479%, and the fed-funds rate, which stands at 1% to 1.25% (see chart below).

'Wrong instrument for wrong device'

Employment data and purchasing managers index readings are at levels that both "generally imply overheating and a Fed aggressively pinching off the excesses with higher rates," he said. RenMac's Master Employment Index is now in the 90th to 100th percentile, which is historically negative for S&P 500 forward returns, he said, as it signals the economy is running too hot.

PMI readings are also in the top decile, which also points to a negative impact on S&P returns three and 12 months forward, he said.

But the Fed's preferred thermostat, inflation, remains in the bottom quartile, he worries.

"That's a little like judging the heat in a microwave by touching the door," he said, calling it the "wrong instrument for the wrong device."

-William Watts; 415-439-6400; AskNewswires@dowjones.com


(END) Dow Jones Newswires

10-06-17 0719ET

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