Seeking Alpha

Not Trusting The A/D Line

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Includes: AAPL, GPS, JWN, LB, RSP, SPY
by: WMA, LLC
WMA, LLC
Value, Growth, portfolio strategy
Summary

Market breadth may not be as reassuring as equity strategists are saying.

We present our in-house market-based indicator of market breadth.

Advance/Decline lines are being skewed by the index investing craze.

We are getting another taste of 2017. Every day, the U.S. equity indexes rise, and every day, CNBC has the red banner "Record Close Watch" on the bottom of the screen. Equities are melting up once again on a combination of real optimism over trade, a friendly Fed, and FOMO (fear of missing out). The challenge for investors today is judging just how much is too much. There is a lot of talk about being a long-term investor, but when the market turns down and paper gains turn to losses, the "long-term investor" narrative dries up like a Texas creek during a drought. Our point: most investors will want to sell (or "lighten up", euphorically, in fund manager jargon) at some point, but when?

The Advance/Decline line is frequently touted as a good measure of market breadth. The A/D line plots the difference between the number and/or volume of advancing and declining stocks on a daily basis. The A/D line is used to show market sentiment, as it tells traders whether there are more stocks rising or falling. It is used to confirm price trends in major indexes and can also warn of reversals when divergence occurs. When fewer stocks participate in the broad market rally, the A/D line will turn down, even before the market cap-weighted broad equity indexes. That is, a few big stocks are pulling the market cap-weighted indexes higher.

We hear many market analysts are reassured that the A/D line is confirming the S&P 500 uptrend. We are less sanguine about market breadth. Especially when the largest stocks in the indexes, like Apple (NASDAQ:AAPL), are more crowded than Disney World in August. At WMA, we like looking at alternative market-based indicators. One alternative indicator of breadth that we use is the comparison of the S&P 500 index (SPY) to the S&P 500 Equal-Weight Index (NYSEARCA:RSP). To recall, the S&P 500 index is a market capitalization-weighted index. Just over 22% of the S&P 500 Index weight is in the top 9 companies:

The top 100 companies in the index (S&P 100) account for over 66% of the index. The other 400 companies contribute less than 34% to the S&P 500. Meanwhile, in the S&P 500 Equal Weight Index, all companies weigh 0.20%. Apple's stock contributes the same to S&P 500 Equal Weight performance as does the stocks of L Brands (LB), Gap (GPS) or Nordstrom (JWN).

In theory, when times are good, investors are confident in buying all companies, including the "riskier" mid caps in the S&P 500. When investors anticipate difficult market conditions, money flows into the blue chip stocks. At least, this WAS the theory.

Let's look at our S&P 500 Equal Weight-to-S&P 500 relative indicator historically. From 2003, U.S. stocks entered a new bull market following the tech bubble bust. We saw that the S&P 500 Equal Weight Index outperformed the S&P 500 Index (rising blue line) until about January 2007, when the blue relative index line topped out and began trending down. A downward sloping blue line indicates more money flowing into big caps (or less money coming out of big caps).

For us, the 2003-2009 episode is how stock rotation "should" work. During good times, investors buy riskier mid caps, and during crisis/recession times, investors flood into the Dow blue chips companies.

We saw normalcy at the beginning of the bull market from 2009. As the Risk-On trade resumed in March 2009, investors went back into smaller cap stocks (rising blue line). We had broad market participation, the equivalent of a strongly rising A/D line. During the turbulence in 2011-2012, when there was much talk of a "double dip recession" and people thought that the rally off 2009 lows had come too far, the blue chip in the S&P 500 outperformed (falling blue line). And in 2013, once sentiment moved back to Risk-On (remember the Fed's QE forever?), the S&P 500 Equal Weight Index again outperformed.

In 2014, the market dynamic changed. There was a realization that stocks had come too far relative to the sluggish economic expansion. Investors became cautious and favored blue chips. During the sideways market in 2014-2015, money was relatively flowing into blue chips (falling blue line). In fact, since 2014, blue chip mega cap stocks have not stopped being the favorite choice of investors.

Here is our take. First, investors' actions (if not words) suggest that most people realize that the low-risk early phase of the bull market is long since over. Buying anything and seeing it rise worked in 2009. Investors are now more selective in choosing companies by market cap. And the choice is for solid, safer mega cap companies. Second, given how long the mega cap trade has gone on, we wonder if over-crowded mega cap stocks are still the safest? If all investors are crowded into the Big 5 Tech names (Apple, Microsoft (NASDAQ:MSFT), Google (NASDAQ:GOOGL) (NASDAQ:GOOG), Amazon (NASDAQ:AMZN), and Facebook (NASDAQ:FB)), what stocks will be sold when the next recession hits? Well, the stocks that investors are holding. Finally, an observation on why the phase of S&P 500 Equal Weight Index under-performance has lasted 5 years (and counting) at the end of this bull market and only lasted 10 months in 2007. We think that this is mainly due to the passive index investment craze. Everyone is now buying S&P 500 index funds. And when $100 flows into an S&P 500 index fund, the manager uses $22 to buy Apple, Microsoft, Google, Amazon, etc. In other words, index investing is by definition sending relatively more money into the mega cap and less into L Brands, Gap, and Nordstrom. Ergo, our blue line keeps falling.

Bottom line

The index investing craze is distorting breadth indicators to some degree. Using an A/D Volume Line is senseless today as trading is concentrated in the mega caps. Our S&P 500 Equal Weight-to-S&P 500 relative indicator is telling us that the equity trade is in fact narrowing. Is the market healthy if equity gains come only from a handful of mega cap stocks? The answer probably lies in just how long investors collectively believe that passive index investing is the holy grail. Each investment style has its day (or years) in the sun. We believe that the art of careful stock picking will soon be appreciated once again.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.