An Early Warning Sign or Another Buy Signal?

Despite everyone’s growing concerns with… well… you name it – the economy, the president, the missiles popping off in Pyongyang – U.S. stocks are having a pretty good year.

Not as good as foreign stocks, as I explained two weeks ago. But still, the S&P 500 is up 9% year-to-date.

That’s roughly the long-term average for annual returns.

So, really, what’s there to worry about?

Stock prices always have the “last word,” in debates over valuation, risk, and the like. And since stock prices are indeed moving higher, it seems like, for now at least, all the worry has been for naught.

Although, fully outside the typical fodder of the news cycle, there is one development I’m watching closely, since it has the potential to either be an early warning signal… or, counterintuitively, a “buy” signal.

Let me explain…

I’m watching what we analysts call “market breadth.”

You see, the S&P 500 is an index of stocks. Its value is calculated based on the closing prices of each of the 500 stocks included in it.

Most people simply glance at the value of the S&P 500 index… and judge it based on whether it’s moving higher or lower.

But market breadth goes one layer deeper, aiming to determine what percentage of the individual stocks within the index are trading in a bullish or bearish manner.

As I explained to my Cycle 9 Alert subscribers yesterday, the percentage of S&P 500 stocks that are trading above their 200-day moving average has been slipping lower in recent months.

And that has some analysts worried.

On March 1, a full 79% of them were trading above this closely-watched line in the sand.

Today, just 59% are holding above it.

That means around 100 individual stocks in the S&P 500 have fallen below their 200-day average in the last six months.

Meanwhile, the index itself is up about 2%… which means fewer and fewer individual stocks are doing the heavy lifting to move the index higher.

Those are the facts… the data, in black and white.

The conclusion we should draw from this data, however, isn’t so clear.

It can be interpreted in one of two ways…

The Negative

The negative interpretation is that this is the beginning of the end.

Logically, since this metric has already fallen from 80% to 60%, today – what’s stopping it from falling further… to 50%, then 40% and, eventually, 10%?

Indeed, by the time only 10% of S&P 500 stocks are above their 200-day average, the broad market will very likely already be in a bear market.

That’s why a divergence between declining market breadth, and a timidly rising index, can often provide an early warning signal of trouble to come.

We here at Dent Research are obviously watching closely for these types of divergences, since we want to give passive investors as much of a heads up as we can.

But that doesn’t mean you should sell everything today and run for the hills!

Far from it… since there’s another equally valid conclusion that can be drawn from reasonable degrees of declining breadth.

The Positive

You see, it’s unreasonable to expect all stocks, across all sectors, to perform superbly all the time.

Even during bull markets, you can find plenty of stocks that are either laggards or downright losers – at least for some period of time.

This is completely natural. And as long as the vast majority of stocks aren’t sucking wind, it’s a perfectly healthy function of the market to have both outperformers and underperformers.

It provides a “cleansing” function for the market, by pushing the prices of out-of-favor stocks lower… until those prices are low enough to attract opportunistic buyers.

And then, most of the time, the broad market continues higher once the laggards are bought in sufficient quantities.

Consider a simple study I ran…

I looked at each instance when the percentage of S&P 500 stocks trading above their 200-day moving average fell below 60% (the condition we’re experiencing now).

Here’s a table showing the average S&P 500 return over the next one to six months, along with the “win-rate,” or accuracy of the buy signal.

As you can see, S&P 500 breadth falling below 60% is not a death knell each and every time. Most of the time, the broad market tends to recover following these cleansing periods.

Which Will it be This Time?

Of course, it’s impossible to say the significance of this signal this time around.

As is often the case with systematic investing, all we can do is “watch and wait” as this situation unfolds. And, of course, I’ll continue to follow the rules of my systems.

You see, Cycle 9 Alert is specifically designed to capitalize on this leaders-and-laggards nature of the market. The fact that 40% of S&P 500 stocks are below their 200-day averages is of only minor importance to my Cycle 9’ers, since those aren’t the type of stocks I recommend they buy.

And since our holding periods are short – typically between two and three months – we don’t have to worry all that much about whether this ends up being the “beginning of the end,” or not.

We’ll simply continue trading the system… which will, inevitably, adapt to changing market conditions, whether positive or negative.

So, while I indeed have my eye on the S&P 500 and market breadth, I’ll continue to run my Cycle 9 Alert game plan no matter what happens next.

To finding profits,