The Russell 3000, a broad equity index representing 98% of the investable U.S. stock market, is up 9.3% for 2014 on a total-return basis.
So, it might surprise you to hear that the median total return for Russell 3000 constituents is just 1.5%. This lower return largely reflects the fact that small- and mid-cap stocks are underperforming.
However, many large caps are beginning to lag, as well.
In fact, there’s currently an alarming deterioration in breadth, a term that refers to how much of the market is participating in the advance.
This raises the question: Is the stock market sitting on a trap door?
Trap Door Indicator #1
One way to gauge market strength is to measure the percentage of stocks trading above their 200-day moving averages:
In early July, more than 90% of S&P 500 constituents were trading above their 200-day moving averages.
Since then, that figure has dropped to 75%… yet the Index has continued to advance.
This narrowing participation in the stock market rally is definitely not a good sign, despite all-time highs in the Index level.
The market capitalization weighted S&P 500 is heavily influenced by the largest constituents, such as Apple (AAPL), Microsoft (MSFT), Berkshire Hathaway (BRK.B), Johnson & Johnson (JNJ), and Wells Fargo (WFC), which have been performing admirably.
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In other words, the mega caps (greater than $100 billion in market cap) are propping up the indices and masking broader market weakness. Meanwhile, institutions are rotating into safer stocks as market leadership is becoming increasingly confined to larger, more stable companies.
This breadth deterioration is reminiscent of similar action in late-2007 and mid-2011, both before significant selloffs.
Trap Door Indicator #2
Another way to assess weakness is to examine how many Index members are trading very poorly.
As you can see below, over 10% of the Index is making new four-week lows.
Fresh lows seem to be expanding. This month, new four-week lows reached 26%, higher than peaks in early July.
Even more surprising is the fact that 25% of S&P 500 stocks are down 10% or more from their 52-week highs. And 30 stocks are actually down 20% or more from their 52-week highs, meaning they’re already in their own bear markets!
Lousy breadth is not indicative of a healthy stock market, although this situation can persist for an extended period of time (like the period leading up to the apex of the technology bubble).
Bottom line: Market internals are currently not confirming the all-time highs for the S&P 500 Index. This type of narrowing leadership has been a feature of significant market tops in the past, and shouldn’t be ignored.
So, you can add bad breadth to the growing list of warning signals and divergences.
Alan Gula, CFA