Don't Let The 'Narrowing' Market Scare You

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Includes: IYR, XLV
by: Clif Droke

Summary

Analysts are highlighting the narrowing trend in S&P 500 Index stocks.

Investors shouldn't worry as broad market breadth is still strong.

Focus should instead be on the areas of relative strength.

A recent surge in M&A deals, coupled with a visibly narrowing stock market, has prompted speculation among pundits that the end is near for the U.S. equity bull market. Articles appearing in a number of well-known financial publications and online portals, including the venerable Wall Street Journal, have openly begun questioning whether the top is in for stocks. As we’ll discuss in today’s report, however, when contrarianism takes center stage it is more likely than not to be disappointed. I’ll argue here that those who expect the bull to die in Q4 will be disappointed.

Analysts and commentators have begun their annual hand-wringing exercise as we enter the fourth quarter. October has a history of being a scary month for investors, with the stock market experiencing several infamous October plunges over the years. With this in mind, analysts have increasingly become concerned about the growing number of companies in the S&P 500 Index (SPX) which have failed to keep pace with the top performers. Although the S&P has climbed by an impressive 9% in the year to date, shares of approximately 200 companies in the index are showing losses for the year through September. Some of them are even in bear market territory.

The increased weakness among a growing number of S&P 500 Index components has prompted many observers to assume a bearish posture on the broad market. The rationale for this defensive stance is that Wall Street is putting all its eggs in a smaller number of baskets with a small number of big names responsible for most of the market’s gains. The problem with this narrative is that it isn’t entirely true. The S&P 500 is a measure of the large cap universe of stocks and doesn’t represent the entire stock market. To get a broader measure of whether or not most stocks are rising or falling we need to consult the much larger NYSE stock universe, which represents around 2,800 companies.

While there have definitely been signs of internal weakness in some quarters of the market in recent weeks, the majority of Big Board-listed stocks are still showing a reasonable level of strength. The bellwether which is most commonly used to measure the degree of participation is the NYSE advance-decline (A-D) line. As you can see in the graph below, the A-D line is still in a rising trend above its widely watched (and psychologically significant) 50-day moving average. As long as the A-D line isn’t making a pattern of decisively lower highs and lows, investors should avoid the temptation to sell out prematurely. The A-D line is historically an excellent measure of the stock market’s intermediate-term (3-9 month) strength. Since it’s above the 50-day MA, the implication is that in the NYSE stock universe there currently is no breadth problem.

NYSE A-D Line

Source: StockCharts

Another measure of participation can be seen in the Nasdaq advance-decline line, which shows us whether the important tech sector is doing its part to support the bull market. Shown below, the Nasdaq A-D line is also still trending higher above its rising 200-day moving average - another widely followed trend indicator. Bear markets normally don’t begin without significant erosion in the A-D lines of either, or both, the NYSE and the Nasdaq. With the important Nasdaq breadth indicator still in expansion mode, the “top is in” narrative has even less credibility.

Nasdaq A-D Line

Source: StockCharts

A final consideration is the incremental demand for equities which, it could be argued, is the most important of all stock market technical indicators. This is measured by the new 52-week highs and lows on the NYSE and Nasdaq. When more stocks are making new highs than new lows on cumulative basis, there is no reason for assuming that selling pressure is a major problem. If distribution were underway it would show up in the new 52-week highs and lows.

When we examine the highs and lows, what do we find? While there has been a definite increase in the number of 52-week lows on both major exchanges, most of the new lows on the NYSE have been rate-sensitive income funds. There has been little signs of selling pressure in most major sectors, which is encouraging. It can be concluded that the elevated number of new 52-week lows on the Big Board is largely attributable to the recent increase in U.S. Treasury yields, with income securities and rate-sensitive stocks facing increasing pressure. This can create a short-term undercurrent of weakness that can trip up the major averages - as we saw in February. But unless the selling pressure is broadly based, any setback in the major averages suffered as a result of income fund weakness should be shallow. Further, with earnings and revenue growth momentum still strong, the market should quickly recover from any such setbacks.

Here is what the cumulative new 52-week highs-lows looks like for the Nasdaq. As you can see, the highs-lows indicator for the Nasdaq is still in a rising trend which indicates that incremental demand for tech stocks is still strong. Indeed, the tech sector is still on a rip-and-tear as reflected in this indicator, and with tech leadership an important component to the stock market’s overall strength there is no reason to fear the bear’s appearance anytime soon.

Source: WSJ

While the stock market’s intermediate-term technical and fundamental position remains strong, the immediate-term (1-4 week) outlook is considerably less certain. There has been a surfeit of stocks making significantly more than 40 new 52-week lows on both exchanges of late. Even though a substantial number of the new lows have been income funds, it’s still a sign that the market is vulnerable to weakness in the immediate term. As I’ve emphasized in recent commentaries, investors should therefore prepare for a possible increase in volatility in October. I offer no prognostications on the magnitude of an October pullback, only a basic warning that the odds of one have increased with the continued trend in triple-digit new 52-week lows on the NYSE and double-digit new lows on the Nasdaq. Until we see the new lows diminish to below 40 for several days on both exchanges I therefore recommend that investors hold off on initiating new long positions in stocks and ETFs.

I would also point out that real estate equities have lately been feeling the pressure from rising rates. By way of disclosure, I have sold my long position in the iShares U.S. Real Estate ETF (IYR) after it decisively violated its 50-day moving average (below). A rising rate trend will also likely exert increasing pressure on real estate stocks and ETFs in the coming month. Investors should instead focus on the sectors and industries which are outperforming the S&P 500 and therefore in a position of relative strength. This includes technology, health care, and consumer discretionary.

iShares U.S. Real Estate ETF

Source: BigCharts

Among the top relative strength leaders right now are the health care stocks. The graph of the Health Care Select Sector SPDR (XLV) reflects this strength as it has made a continuous pattern of new highs in the last two months. Health care stocks remain immune from the pressures of rising rates, rising oil prices, and a strong dollar. There is also clear evidence of rotation into the health care providers as investors seek out the best stocks from industries which are fairly stable, less sensitive to news-related surprises and with the greatest growth potential in a rate-sensitive stock market. Health care stocks generally fall into this category. The fact that there are still plenty of conspicuous areas of strength in this is another reason why investors shouldn't get scared into thinking that the stock market is too narrow.

Health Care Select SPDR

Source: BigCharts

On a strategic note, investors should also continue to maintain a longer-term bullish exposure to the stock market via ETFs and outperforming individual stocks in strong sectors. This includes in particular the retail, transportation, and tech sectors, which have all shown relative strength versus the S&P 500 Index in recent months. I also recommend raising stop losses on existing long-term positions and taking profits in stocks and ETFs which have already had impressive upside moves.

Disclosure: I am/we are long XLK, IJR, XLV.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.