How Strong Is The Stock Market?

retirementMy Comments: For many years, more than I care to remember, I searched for wisdom from among the many magazines and more recently, the many emails that cross my desk on a daily basis. How and what was going to happen and how could I help my clients benefit from the insights that surely came my way?

Last week, the S&P500 hit a new high water mark. And since we are now in unchartered waters, what rocks, sandbars and whirlpools lurk in the shadows?

I don’t have a clue. All that wisdom imparted to me by those magazines and emails mean very little. All I can do is review the past and whenever possible, draw conclusions that will hopefully presage the future. The best thing I know to do is position yourself in such a way that folks smarter and wiser than we are assume a caretaker role, one that we can monitor and make changes when it’s obvious we and they were wrong,

By Chad Karnes / Feb. 27, 2014

The S&P made a new intraday all time high on Monday, 2/24, hitting 1,858. Although it couldn’t hold that level and sellers sent prices back below the all time closing high of 1,848 from January, the market’s strength is undeniable.

Or is it?

Real Strength
The S&P 500 is a market cap weighted index whose price is derived from a basket of 500 stocks within it. The change in its value is derived by adding up all the weighted changes of its 500 individual components. Multiplying a company’s change in price by its weight in the index gives its weighted change and thus effect on the overall Index.

The top three companies by weight in the S&P 500 are Apple (AAPL), Exxon Mobil (XOM), and Google (GOOG). Together these three companies make up 7.5% of the total S&P 500’s price. If they collectively move up 10%, the S&P would move up 0.75%.

On the flipside, the three smallest companies in the S&P 500 are Diamond Offshore Drilling (DO), AutoNation (AN), and Graham Holdings (GHC). Collectively, these three companies make up only 0.06% of the S&P 500. If they all doubled in price, the S&P would not even budge, only rising 0.06%.

80/20 Rule
Just 200 of the S&P 500 stocks make up 80% of the entire index’s value. The bottom 300 companies are essentially dominated by the larger market cap ones.

The above breakdown of the S&P 500 displays one of the key weaknesses of the S&P and most stock indices. They can be misleading.

The S&P just made a new all time high which on the surface seems like a great development but take a look at the chart below.

What the above chart shows is the number of S&P 500 stocks in an uptrend as measured by whether their price is above their 200 day moving average. Quite clearly this chart is not making new all time highs and in fact is in a downtrend, showing that less and less stocks in the S&P 500 are participating in the rally. 19% of companies in the S&P 500 are in downtrends, the most at any new S&P price high since the rally from 2009 began. More so, the declining trend in companies above their 200 day moving average is also a first as the market makes new high after new high.

In our 1/20 Technical Forecast, just as the markets were topping and on their way to a 6% pullback, I provided a similar chart along with other indicators and commentary for our subscribers with this warning:
“The % of stocks above their 50 day moving averages peaked in February and again in May along with new all time highs. Since then, the peaks have not shown as much participation and display a market that makes new all time highs, but on the backs of less and less stocks. A breakdown of 60% (of stocks above their 50 day) accompanied all the market pullbacks in 2013 and again will be a warning that a majority of stocks are nearing downtrends and a larger selloff is likely.”

A decline below 60% occurred later that week as the market was on its way to a 6% pullback.

The declining breadth (as the chart above shows) continues through today and helped us warn subscribers of the overall weakening trend in stocks, regardless what the broader index was suggesting. This development makes the markets more susceptible to a large pullback.

The broader index may be making new all time highs, but less and less of its components are. This means the market is being driven higher by fewer and fewer companies and solely by those companies with the biggest market caps that have the larger effects on the Indices.

These stocks will only be able to pull the market higher for so long as valuations and momentum eventually become too lofty for sustainability. The increased risk of a rising market on less and less support was foreshadowed with January’s 6% pullback.

A market that rises on less and less support is one that is very fragile as there are less companies to pick up the slack if one of the leaders goes out of favor. The declining trend in stocks above their moving averages (and new 52 week highs) also shows a market that is tiring.