An Early Warning Signal for U.S. Stocks

When everything is good, start worrying... What most stocks are telling us today... Down goes breadth – from record highs... An early warning signal for U.S. stocks... Video: The banks are in bed with the Fed...

Don't be fooled...

The benchmark S&P 500 Index and tech-heavy Nasdaq Composite Index hit new intraday highs early this morning... More people appear to be going back to work... And signs telling us to wear masks are finally disappearing from most doors.

In other words, a cursory look at U.S. economic indicators would tell you the big picture has been improving in recent months and better months are ahead... And that might be true, generally speaking.

But when it comes to stocks, when "everything seems good" with the economy – which we know isn't really the case (hello, inflation) – that's exactly when you want to be ready for the "bad" to happen...

We've talked about this simple yet very important idea before... which is often forgotten or never learned in the first place.

Here's how True Wealth editor Steve Sjuggerud described it in mid-May 2020. Back then, many folks wondered how stocks could be hitting new highs while many people were still scared of the COVID-19 pandemic...

There's an important truth you need to understand. It's simple and perfectly explains what's happened in recent weeks...

The U.S. stock market operates on a different time cycle than the U.S. economy.

Stocks tend to move much faster than the economic environment. They anticipate what's coming. That means stocks are the first to fall during tough times... And they often rally before the economy even begins to recover.

Today is one of those times when you want to pay close attention to this idea... When we do, we see trouble lurking for stocks in the months ahead beneath the happy economic headlines.

In short, the major U.S. indexes may be creeping to new highs every few days. But if you look closer, you'll see that the market is telling us something different than "all is well"...

All is not well. The number of individual stocks hitting new highs each day has been decreasing as of late... Plus, an increasing number of stocks are starting to trade below their long-term averages (though that is only down slightly from a record high).

When this combination happens, it's usually an early indicator that a broader sell-off in stocks could be ahead... or at the very least, that we're closer to a top than a bottom.

Every investor would love to nail the 'top'...

The truth is, "tops" – peaks in prices – often reveal themselves slowly... and only appear crystal clear in retrospect.

But at the same time, you can see them developing – like a tornado on weather radar – if you know where to look and what signature behavior to seek. And fortunately, our editors can help you do just that...

First, if you're worried about broad market sell-offs and want to avoid them, then you obviously want to look at indicators that show what the broader market is doing today...

We can do this most broadly by looking at the roughly 2,800 stocks that trade on the New York Stock Exchange ("NYSE") – the so-called NYSE Composite Index – and then looking at the individual behavior of these same stocks.

Looking at the NYSE Composite Index, which includes everything from blue chips to small caps, helps us go beyond even the S&P 500, the Nasdaq 100, or the Dow Jones Industrial Average to see what most stocks are telling us today.

This might sound like a daunting exercise, but it's actually pretty simple...

One way is to compare the performance of the stocks in the NYSE Composite with the percentage of those same stocks that are trading above their 200-day moving averages ("200-DMAs"). The fancy term for this is "market breadth."

Readers who've followed us for a while know that the 200-DMA is a good technical indicator of a long-term price trend of any asset – from bitcoin to beans... That's because 200 days equals roughly 40 trading weeks, or nine months.

If the indexes were to keep rising, you would expect the number of individual stocks in uptrends within them to keep increasing, too. But that's NOT what is happening today...

You can see a trend 'flip' in this chart...

The black line shows the value of the NYSE Composite. And the blue line shows the percentage of NYSE stocks above their 200-DMAs at any point over the past two years...

Coming out of the last major market bottom in March 2020, the major indexes predictably rose as individual stocks started to trade higher and more folks became less scared and piled back into the market.

Eventually, it reached a point in November and December 2020 where more than 85% of NYSE stocks were in nine-month uptrends. We thought this may have been an early sign that a "breadth" peak was upon us... Surely it couldn't last forever.

Extremes like these don't typically last very long at all. But looking back now, in July 2021, we see that we were wrong...

Remarkably, the trend held for months for whatever reason (though we'll chalk it up to the unprecedented fiscal and monetary stimulus, also known as the "Melt Up").

And ultimately, this indicator hit new highs of roughly 90% for weeks in February, March, and April... That's a type of stretch not seen since 2009 and 2010, in the early years after the last financial crisis.

But then, things changed. Just look back at the chart to a few months ago...

Around April of this year, the NYSE Composite kept climbing to fresh highs, despite the number of stocks in long-term uptrends starting to drop to the levels from the end of 2020... albeit from the absurdly high peak of about 90%.

Relatively speaking, that means for roughly the past two months, fewer stocks have been heading higher while the headline indexes have still been hitting new highs...

This is not what you would expect to see in the strongest, healthiest bull markets.

As my friend J.C. Parets from AllStarCharts.com wrote recently...

There are stocks going up and there are stocks that are not going up. What you're not really seeing is many stocks going down. That's probably the best way to describe this market.

It's the same story for the S&P 500... About 95% of stocks in the index were in uptrends as of mid-April. Today, it's at 90%. That's still near historic levels... So again, we might be early in this trend, but it's one you'll want to pay attention to in the coming weeks.

The number of stocks making 52-week highs has also decreased significantly in recent weeks... Only 8% of the stocks in the S&P 500 hit new highs last week.

We can guess why this is happening now... For one thing, it seems like all the good pandemic recovery news has been "priced in," as every major sector has now had a major rally since March 2020 – even banks and oil.

As Michael Wilson, chief U.S. equity strategist at Morgan Stanley, wrote in a note to financial-news outlet CNBC today...

The U.S. economy is booming, but this is now a "known" known and asset markets reflect it. What isn't so clear anymore is at what price this growth will accrue. Higher costs mean lower profits, another reason why the overall equity market has been narrowing... equity markets are likely to take a break this summer as things heat up.

The next "unknowns" from here are things that can go wrong. We're not talking about if or how we'll recover any more...

We're talking about the Federal Reserve facing pressure to taper asset purchases and hike interest rates in the face of higher inflation and jobs starting to come back...

And as we wrote in the June 11 Digest, beyond that, we're looking at a possible change in central bank leadership or another winter COVID-19 panic, which could both roil stocks.

Ten Stock Trader editor Greg Diamond is also seeing signs of weakness and other 'divergences' below the surface...

Right now, Greg is keeping his eyes on important sectors and industry leaders in manufacturing and technology. But he's also looking abroad for clues about "what comes next"...

And as he wrote this morning to subscribers in his Weekly Market Outlook...

One particular fund that just cannot rally is now catching my eye... the iShares MSCI Emerging Markets Fund (EEM). Here is the chart...

It's a simple analysis here. EEM topped out on February 16 and has failed to even test those highs since. That's not exactly strong price action, especially when you consider the S&P 500 and Nasdaq 100 continue to march higher.

Greg explained that this is exactly the same behavior in emerging markets that happened before a 25% sell-off in the S&P 500 at the end of 2018, and at other times. As he wrote...

There are examples throughout history where U.S. stocks, for whatever reason, are the last to get the message that capital is retreating from the global stock market – perhaps it's because the U.S. is the largest economy in the world, perhaps it's a failure of investors to look globally...

I don't really know the exact answer as to why. But I do know that it happens time and time again – when capital starts to move in the opposite direction, just like bitcoin and EEM, it is wise to pay attention for what domino falls next...

And it can take a while for this to unfold. If EEM reverses course and starts rallying, it will be good for U.S. stocks. But right now, it is not, and that is what concerns me in the months ahead.

The "divergences" look even more startling when you look at the top emerging-market stocks...

Industry leader Taiwan Semiconductor Manufacturing (TSM) is lagging. It's down about 15% from its February 16 high... Tencent (TCEHY) looks like it topped on February 12... And Alibaba (BABA) hasn't hit a new high since way back in October 2020.

As Greg wrote...

I am still bullish on stocks in the U.S. But I wanted to highlight this important part of the global stock market, because this may be setting the stage for a round of volatility that can catch some investors by surprise.

Indeed, we're due for some volatility. As Dan wrote in the June 18 Digest, the market's "fear gauge" – the CBOE Volatility Index ("VIX") – has been trending lower...

New investors might look at this chart and say "that looks great"... But longtime readers know we like to look at the VIX as a contrarian indicator. When too many people are bullish (or bearish), the opposite result can happen...

We're not all the way back to pre-pandemic "complacency" – which would suggest that investors have gotten completely over their fears – but we're getting close... And at the same time, we also haven't seen a major spike in volatility since early May.

Admittedly, though, as Greg alluded to, it might be a bit too early for an urgent 'crash warning'...

After all, 80% of stocks on the NYSE are in long-term uptrends... That's still well above average.

And even after "breadth" peaks, stocks historically have run higher for as long as 18 months. As I wrote in the December 10, 2020 Digest...

During the dot-com boom, breadth peaked in early 1998... The stock market peaked in 2000.

More recently, breadth surged in 2013... then the benchmark S&P 500 Index rallied 45% before peaking in 2015. And in 2016, breadth surged again... and stocks went up another 35% into 2018.

But even the biggest bulls should consider this an early warning sign if they're heavily invested in stocks... Despite "new highs," fewer stocks today are heading higher than a few months ago.

And this is happening at the same time that retail investors are piling into stocks in record numbers. As our colleague and Stansberry NewsWire analyst Nick Koziol reported today...

According to data from market research firm VandaTrack, individual investors plowed $28 billion into stocks in June. That was the largest single-month inflow into stocks for the retail investor crowd since 2014, based on VandaTrack's data.

Those weren't the only data showing retail investor bullishness. A separate report from Sundial Research said that 70% of individual investors see stocks rising over the next quarter, according to the Wall Street Journal. That's compared to just 44% of investment "professionals," the WSJ said.

Our colleague Dr. David "Doc" Eifrig wrote recently that in April, 41% of U.S. household wealth was allocated to stocks... That's higher than during the dot-com peak (37%).

As longtime readers know, retail "euphoria" is a sign that Steve's Melt Up thesis is still intact. This behavior is part of the deal on the way to the other side of things...

The inevitable "Melt Down."

Remember, an astounding 90% of stocks on the NYSE and 95% on the S&P 500 traded above their 200-DMAs in mid-April... That means if you picked any major stock in the U.S. last summer, you had a 90% to 95% chance of seeing positive returns in that stock this spring.

No wonder people have gotten euphoric.

And over the past six months or so, we've seen wild speculation in various pockets where money can be gambled... the rise of the GameStop (GME) and AMC Entertainment (AMC) short-squeezers... highly leveraged bets in cryptos... non-fungible tokens... and even invisible art.

Don't be surprised if the trend hits stocks next... while the story below the surface tells smart investors something different.

Keep in mind, though... this doesn't mean stocks will crash tomorrow, next week, or even six months from now. The thing about trends is that they can go on longer than most people imagine.

But you don't want to be caught off-guard, either. So consider this an early warning sign.

The Banks Are in Bed With the Fed

The Federal Reserve gave U.S. banks a "thumbs up" as all 23 lenders easily passed their latest "stress tests." Best-selling author Nomi Prins says this is "not-so-shocking news... the biggest banks are OK after nearly 13 years of zero interest rate policy."

Speaking with our editor-at-large Daniela Cambone, Prins explains, "the Fed 'only' had to buy $8 trillion of assets with fabricated money along the way. So now Wall Street's given the green light for another round of record-setting buybacks"...

Click here to watch this video right now. For more free video content, subscribe to our Stansberry Research YouTube channel... and don't forget to follow us on Facebook, Instagram, LinkedIn, and Twitter.

New 52-week highs (as of 7/5/21): Freehold Royalties (FRU.TO). U.S. markets were closed in observance of the Independence Day holiday.

In today's mailbag, Dan answers a question stemming from his latest Friday Digest. Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"Dan, I heard it on your podcast and thought you interpreted it incorrectly and now I read it today:

According to our friend Jason Goepfert at SentimenTrader.com, the correlation between value and growth stocks has never been lower going back to 1928. That means investors have never cared about the difference between value and growth more than right now.

"Is that interpretation Goepfert's or yours? I interpret low correlation to mean that the prices of value stocks and growth stocks have not been moving together. 'Uncorrelated' does not necessarily mean that either price is 'out of line.' It means that owning both value stock and growth stocks provides diversification.

"Usually doing a pairs trade, I do it when they are historically 'out of line' and I assume that there will be a reversion to the mean. Often the hard part is to determine 'the mean' to which it will revert. Easier to look at a long history of the relative prices of commodities such as gold to silver. Not so easy to look at 'value' of growth vs. value. Price-earnings ratios are of some use, interest rates should be considered along with the current stage of the business cycle.

"It is nice to benefit from long trends in any of these. Patience is of value in doing this.

"I enjoy your idea of playing with the relative values of growth vs. value stocks. I have done it with IWN and IWO in the past. I also play with the large caps vs. small caps in the futures market with /ES vs. /RTY or in stocks with SPY vs. IWM. I am currently long more silver than I am short gold.

"Keep up your good work." – Paid-up subscriber Bill H.

Dan Ferris comment: Bill, thanks for the note. It's my interpretation, not Jason's.

Yes, you're technically right... I'm just making a casual observation about the investor attitudes that push the correlation lower.

I'm saying the higher the correlation, the less anyone in the market cares about the difference between the two. The lower the correlation, the more investors seem to care. As the correlation falls, it seems like somebody in the market cares a lot about owning one asset at times when they're selling the other.

So yes, a prudent investor might say, "Low correlation simply means I can own the two and be diversified." But at the same time, a typical investor says, "Value is still terrible, so I'm selling it and buying growth," or vice versa... possibly helping to push the correlation even lower.

All the best,

Corey McLaughlin
Baltimore, Maryland
July 6, 2021