It doesn’t take much more than a glance at the S&P 500 to see that stocks are at somewhat of a “make or break” point for the current rally.
Prices have risen much more than most analysts had expected, but they have done so on incredibly thin market breadth. This situation does occur from time to time, and it’s not a guarantee that a reversal will occur, but it is also not an optimal situation.
Having the S&P 500 at resistance this week is actually good timing. Economic releases and the tail end of earnings season will do a lot to help provide better expectations for whether the market is likely to “make” or “break” as we head further into November.
One of the simplest measures of market breadth is the ratio of advancing stocks to declining stocks during a rally. For example, over the last month (trailing four weeks), 80% of the S&P 500 components have experienced gains.
That isn’t the best ratio, but it’s not bad.
What About the Small Caps?
Unfortunately, the picture gets a little cloudy when “risk-on” stocks like the small-caps are evaluated in the same way. Only 65% of the stocks in the Russell 2000 small-cap index are positive over the last month, and only a mere 37% have outperformed the S&P 500 average.
That is extremely surprising considering that October was the best month for the major indices in four years.
Click to Enlarge
In the chart at right, you can see the S&P 500 — as measured by the SPDR S&P 500 ETF (SPY) — compared to a relative-strength study (blue line) between the S&P 500 and the Russell 2000. The comparison line is down-trending because small-caps are underperforming the S&P 500.
This is quite unusual during a robust rally, and it continues to urge a cautious approach to the markets. A divergence like this doesn’t always lead to a downturn, but it’s virtually unheard of for a downturn to start without one.
This week should help to provide more clarity about expectations for the market in the near term. The U.S. jobs report for the month of October was released today, and it should help us understand more about the Fed’s potential plans for a rate hike in December.
Earnings season is wrapping up, and there has been contraction in both average earnings and revenue growth. However, that picture could still improve a bit with the spike in retail reports this week.
Bottom Line
Investors are paying more per dollar of earnings than at any time since the 2008 crash. The negative growth rate in revenue has been a little bit of a surprise and, even if we exclude the energy sector, total economic activity was softer than expected in the third quarter. In order to justify even higher prices in the fourth quarter, we really need to see a shift in the market’s fundamentals.
Based on the lack of confirmation from small-caps, transportation and emerging markets, resistance at the top of the old channel on the S&P 500 seems likely to hold.
We aren’t necessarily bearish yet, but we do think this should encourage a very cautious outlook and a bias towards taking profits in bullish positions as early as possible.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.
