A year ago I published A New Leading Indicator Of Stock Market Direction. It's my most popular article with more than 6000 views and 46 comments. Thanks for your interest. At this time last year, it looked like a correction was just beginning, but as you know that has not materialized. So the indicator has been wrong, so far. But the indicator continues to increase in strength. What are your thoughts? Is the indicator wrong, or just early? Here's the update and a description of the indicator.
The following graph shows the history of the indicator going back to 1998. It forecast the market declines in 2000 and 2008, and it started forecasting another market correction at the beginning of 2016. A high indicator precedes a market sell-off. A low indicator signals a recovery. The returns shown in the graph are the average quarterly returns over the year following the indicator date. They're rolling 4-quarter averages.
I created and maintain the Surz Style Pure® indexes that break the stock market into large, middle and small, and within each of these sizes into value, core and growth. Morningstar style boxes use a similar approach, and were introduced several years after I launched my indexes. My index definition for large companies is the top 65% of the market. I sort the 6000 companies in the US stock market by capitalization and start adding until I get to 65% of the total capitalization.
I've noted that the breakpoint for large companies has recently reached its highest point ever -- $22 billion - in June 2015. A large company by my definition is currently above $22 billion. There are currently 227 U.S. companies that meet this rule, with total capitalization of $16 trillion, which is 65% of the $25 trillion total market size. This large company breakpoint is the indicator shown in the graph above. It has successfully predicted the last two market cycles, and is signaling that a major market decline started two years ago.
So why does this breakpoint indicator work, and most importantly will it work this time? Here are some possible explanations:
- Mega cap market domination is cyclical, and the (capitalization-weighted) market goes where the megacaps go.
- It's just another measure of overpricing, big companies becoming too expensive.
- Investors flee to the safety of big companies when they're worried, and worry ultimately turns into panic.
- It's not a leading indicator at all. The apparent correlations are spurious. Most who commented on my original article believe that this is the case, and so far it would appear they are right.
What do you think? Have I stumbled onto something? What is it telling us about 2017?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.