When more stocks are going down than up, market breadth becomes an issue, particularly when a commonly-cited equity market index, like the S&P 500, is showing strength. At the time of writing this (November 24, 2015), the S&P 500 was only 2% away from its all-time high achieved only six months earlier. One would think the U.S. stock market is strong. When you take a look under the hood though, you see something much different.
When you take a closer look at the S&P 500 index, what you will find is a market-weighted index, meaning that bigger companies, like Apple, have greater representation or weight in such an index. The problem with the market-weighted approach is that it does not represent investors who favor broadly diversified portfolios. For example, during the Tech Bubble, technology giant Nortel Networks represented more than 33% of the entire Toronto Stock Exchange! Such overrepresentation is why equally-weighted indices are sometimes preferred. Furthermore, comparing an equally-weighted index against its market-weighted counterpart could show something unexpected.
If you click on the accompanying graph, then you will see the ratio (green line) of the: 1) equally-weighted (“EW”) S&P 500 index, versus 2) its market-weighted (“MW”) counterpart. When the ratio goes up, like from 2003 to 2006, it means most stocks, including the smaller those of smaller companies, are also going up. When the ratio goes down, like from early-2007 to early-2009, it means most stocks are also going down.
Looking closely at the 13-year graph, there is also a 60-week moving average (gold line). When the ratio crosses from above its upward-trending 60-week moving average (“60-WMA”), it has foreshadowed market crashes. The trend of the 60-WMA is also prescient.
In the first instance (left red circle), the ratio crossed from above its upward-trending 60-WMA in mid-2006, which was approximately fifteen months before the market-weighted S&P 500 peaked and before it crashed spectacularly a year later in what was known as the Global Financial Crisis. In the second instance (middle red circle), the ratio crossed from above its upward-trending 60-WMA in late-July 2011, which was only a week before the market-weighted S&P 500 crashed impressively in what was known as the European Debt Crisis. In each instance, notice also that the 60-WMA flattened before turning down.
More recently, there has been a third instance (right red circle). In late-2014, the ratio once again crossed from above its upward-trending 60-WMA. Just like the first two instances, the 60-WMA flattened before turning down. Though the MW-S&P 500 is only 2% away from its all-time high, the downward trend in the 60-WMA appears to suggest the MW-S&P 500 has already peaked and is on the verge of a bearish predicament. Despite the feelings of déjà vu you may be having, only time will tell how the future will play out. Whether or not you have access to a time machine, please consult an investment fiduciary before making any investment decisions.
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