At the end of July, I discussed some reasons to expect the S&P 500 (SPY) was going to make new highs in August. This prediction has come to fruition as the SPDR S&P 500 ETF (SPY) has gained more than 6% and exceeded its previous high from late-February…
Despite this bullish momentum, there are some warning signs that investors should take seriously:
During the market’s recent advance, market breadth has been abysmal. Breadth is a tool to understand the market’s behavior from a bottom-up perspective. It’s showing that money is flowing into fewer and fewer stocks. If and when selling pressure emerges, stocks will be vulnerable to a steep decline.
In terms of market breadth, the rally peaked in early-June when 98% of stocks in the S&P 500 were trading above their 50-day moving average. Today, that figure is 73%.
We had a similar situation at the beginning of the year. The S&P 500 made a new high in February, however, there was divergence as breadth made a lower high compared to January.
We are seeing a similar divergence now. Fewer stocks are participating in the uptrend. It’s being masked by the strength in the indices, but there’s distribution.
Another perspective is the new highs index. Ideally, as the stock market advances, the number of new highs expands which indicates the rally is broadening out.
However, on this break-out, this is not happening. Instead, the number of new highs is compressing. Additionally, despite the S&P 500 making new highs, the number of new highs on the New York Stock Exchange is nowhere near what we saw at the beginning of the year.
And, this same dynamic is present in the Nasdaq:
An analogy to help you think about breadth, and why it’s important: Think about a business with growing sales. Since sales are increasing, the operators assume that everything is fine.
However, if they take a closer look, they realize they are actually losing customers every month but a small number of customers are accounting for enough sales growth to offset these losses. At an aggregate level, it’s a positive situation, however, the business is becoming more vulnerable since its dependency on these customers is growing.
If they lose one of these customers, then the situation can turn bleak pretty quickly.
Another perspective is by the price action of
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