Warning Flags For The Stock Market

Stock market internals are rapidly deteriorating

Over the past few weeks the internal health of the stock market has markedly deteriorated, giving way to a number of warning flags that could presage unfavourable performance in the short to medium-term.

Most notably, stock market breadth has fallen by the wayside as fewer and fewer participants are partaking in the S&P 500’s rally. Since mid-May, all of my short-term breadth indicators have trended lower while the S&P 500 continues to march higher. Most notably, only 34% of the S&P 500’s constituents are trading above their respective 20-day moving averages while the index trades at all-time highs.

This is seemingly becoming a narrower rally by the day. But what is perhaps more concerning is similar breadth indicators from a longer-term perspective are equally weak. Below is the percentage of stocks within the S&P 500 trading above their 50 and 200-day moving averages, which have both been making lower highs over the past quarter. In addition, the relative performance of the equally weighted S&P 500 index versus the market capitalisation weighted peer has been drastically underperforming for around a year now.

The market concentration toward the Mag-7 (more like Mag-6 now Tesla has left the party) in 2024 has been truly remarkable, but likely unsustainable, at least in the short-term.

It’s not just market breadth which is sending a warning flag, but other measures of market internals are also no longer confirming the recent highs for the index. As we can see below, my market internals model and pro-cyclical index have both diverged lower since early April.

Cyclical sectors have been dramatically underperforming growth sectors, highlighted by the stark negative divergence in my pro-cyclical index. The below chart breaks down this index by its constituents, and as we can see, the relative performance of the retail, transports, consumer discretionary, materials and industrials sectors have all been poor.

While this is also true of market internals as a whole, the negative divergences of the constituents within my market internals index are not unanimous, unlike that of the pro-cyclical index. Credit spreads and semiconductors vs S&P 500 are two internals measures that remain supportive of this rally. Overall, the negative divergences seen in the cyclicals vs defensives ratio, high-beta vs low-beta ratio, VIX term structure and dollar are notable.

What also could have negative connotations in the short-term is seasonality. The back half of June is generally an underwhelming period for stocks, as is the June to September period as a whole. As we approach the post-June options expiration “window of vulnerability” from the 23rd, given the poor market internals highlighted above, there could be room for the index to correct this imbalance to the downside.

It ain’t all bad

While it is clear market internals look very poor at present, are the fundamentals sufficient to cause a bear market? I don’t think so. It is true equity markets have priced in a lot, and the growth stocks and Mag-7 that dominate the Nasdaq and S&P 500 have gotten ahead of themselves from a forward-looking earnings and business cycle perspective, but, the outlook for both remains relatively supportive of risk assets over the next nine or so months. This is why I am more inclined to think we are in for a period of rangebound price action (that could see some kind of 5-10% pull-back) over the next three to four months, as opposed to a material correction or the beginning of a new bear market. The latter seems more likely a story for some time in 2025 than 2024.

Market internals are worrying and are likely to correct themselves via price action to the downside. But it is also true many indicators of stock market health remain relatively neutral, if not outright supportive. We could absolutely see cyclical areas of the market simply play catch-up from here without the index needing to correct at all.

For one, liquidity and financial conditions are still relatively supportive of risk assets. On the negative side, global liquidity growth has been stagnating and stocks are overbought relative to liquidity (hence why a short-term pull-back and or consolidation period seems likely). On the other hand, oil prices, inflation pressures and the dollar are not yet near worrying levels for risk assets.

Meanwhile, total speculative positioning toward stocks has recently retreated back to more favourable levels as speculators have unwound longs over the past month or so. Major market tops are very unlikely to occur when investors are net short stocks.

The category of investors most underweight stocks are hedge funds. Though hedge fund and CTA positioning briefly spiked last month, hedge fund positioning is back to levels most often associated with market bottoms, not tops.

Some measures of positioning and sentiment are extremely elevated; volatility targeting funds, asset managers and the AAII Bulls/Bears spread for example. But I find it difficult to argue we are close to a major top when overall speculative positioning and hedge fund positioning is where it lies currently.

This is especially true when we consider the favourable business cycle and earnings backdrop for the market.

What we likely have is a situation where this has been priced in by markets (at least by growth stocks) and we probably need to see a sentiment washout for those areas of the market which have gotten ahead of themselves. We may also see global stocks outperform large cap US stocks moving forward. This may very well be what the unfavourable market internals are signaling.

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