Stocks have been in a volatile up-and-down trading range all year, but in the past few weeks the swings have been even more intense.
At the same time, market breadth has taken a turn for the worse, which is an ominous sign that a much steeper correction may be in the cards.
Two weeks ago, the Dow and S&P 500 were sitting at the low end of the trading range, threatening to break key support. Then stocks rallied five out of six days from July 10 to July 20, and presto, we’re right back near the highs.
But last week was a total reversal with the Dow falling five days straight through this past Monday. And just like that, stocks are threatening key support levels again. Talk about a flip-flop market!
In fact, last week’s Dow dive into negative territory year to date was the 21st time this year the blue-chip index has flip-flopped from positive to negative (or vice-versa), according to Bespoke Research.
This kind of sideways chop is almost unprecedented. The fact is we haven’t seen this many Dow flip-flops in a single year since 1900!
Also, as you can see in the graph below, the Dow decisively broke its 50-day and 200-day moving averages to the downside last week, before bouncing early this week.
And as you can see, the Dow is now in a downtrend, tracing out a clear pattern of lower highs and lower lows.
Bad breadth adds to investor anxiety
The price action alone is ominous enough, but a troubling deterioration of the stock market’s internal breadth measures makes me even more cautious right now.
Two of the most watched measures of breadth are:
#1 — Advance/Decline: The number of stocks advancing, or moving higher, compared to the number that are declining, and
#2 — New Highs/New Lows: The number of stocks in an index reaching new yearly highs, versus those falling to new lows.
By definition a healthy stock market rally must have more advancing than declining stocks and more shares making new highs than lows, but just the opposite is happening right now.
If you think the chart of the Dow above looks scary, take a look at this …
In the top panel is the S&P 500 Index. You can see the up-and-down swings all year, which have really intensified in recent weeks. But even with all the flip-flops, the S&P is only down 1.2% from its recent high.
Now look at the lower panel of this chart. It shows the number of advancing versus declining stocks on the New York Stock Exchange.
You can see the number of stocks moving up stalled out in April and May and there has been an overwhelming number of declining stocks in the past few weeks. That’s a big red flag.
In other words, fewer and fewer stocks are supporting the overall market. In fact, just a handful of high profile names in the S&P including Amazon, Netflix and Starbucks have accounted for nearly ALL of the market’s recent gains! That’s not sustainable.
Now look at the expanding number of stocks making new lows in the chart below, another clear warning sign.
Again, while the S&P has been flip-flopping from the high to low end of its trading range (above, top panel), the percentage of stocks falling to new 52-week lows has surged (bottom panel). Also noteworthy is that just 37% of S&P 500 stocks remain above their 50-day moving average of price (middle panel), a key technical level.
This is a major negative divergence. Think about it; the index is within striking distance of a new record high, and yet there are a growing number of stocks already mired in their own private corrections.
In fact, many stocks are down 15, 20 even 30% or more from their 52-week high!
Finally, probabilities suggest that we’re way overdue for a correction steeper than 3% to 5%. Historically, stocks have suffered a correction of 10% or more about once every two years on average, but the last time the S&P 500 was down even close to that much was over three years ago in 2012!
Bottom line: The stock market’s bad breadth and recent volatile price action is a warning sign you need to pay attention to. This doesn’t necessarily mean you should dump all your stocks and go to cash, but it does mean you should:
1. Consider taking some profits off the table and tighten your protective stops,
2. Raise some cash that can be put back to work at more attractive prices, and
3. You should be ultra-selective with new purchases.
Stick with high-quality stocks (those rated B or better by our Weiss Stock Ratings) and keep a watchful eye on the indicators above: the number of advancing compared to declining stocks, plus the number of stocks making new highs versus lows.
If these breadth indicators don’t improve soon, it could be a sign of a steeper stock market correction to come.