This Market Canary Is About to Keel Over
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If you’ve only been investing since late October, you’ve only felt the UP.
But markets aren’t always balloons and butterflies. Sometimes, stocks need a healthy pullback to set the stage for a sustained move higher.
A few short weeks ago, I made the case for you to get your buy-the-dip list ready. That’s because my favorite technical indicator was flashing a warning sign.
Today, I’m doubling down on this idea. The evidence points to weaker price action in the coming weeks and months.
If history is a guide, we should expect both small and large caps to fall… offering a better entry point than today’s overbought levels.
As usual, we’ll study history to not only back up these claims, but give us a plan of action.
The Market is Weak Beneath the SurfaceTo gauge the overall health of the market, let’s start by reviewing the price action.
Most of us know that the S&P 500 is near all-time highs.
But as usual, that’s only part of the story.
You see, plenty of stocks aren’t participating in the rally. A great way to see this is by looking at equal-weighted stock indexes.
The S&P 500 is weighted heavily towards the stocks with the biggest market cap. For example, the top five stocks in the index, or 1% of all the names, make up nearly 27% of its value.
Equal-weighted indexes treat all stocks the same. In the case of an equal-weighted S&P 500, each stock would carry a 0.2% weighting.
The table below shows the dichotomy between new highs and hidden weaknesses. While the S&P 500 is up 3.73% in 2024, the S&P 500 equal-weight index is down 0.15%.
Even worse, the Russell 2000 small-cap index is drastically underperforming, with a 4.37% drop:
This is what’s called a narrow market, where leadership is led by a few mega-cap companies.
Imagine if only the generals charged into battle, while the army stayed behind. It would spell trouble.
But this is only one of the technical challenges the market faces.
The other, bigger dynamic at play is how Wall Street institutions have started to shift bearish…
My Favorite ‘Canary in the Coal Mine’ Indicator Just Ran Out of AirBack in mid-January I shared that my favorite market indicator, the Big Money Index (BMI) was extremely overbought.
As a reminder, this proprietary indicator plots the trend of institutional buying and selling in thousands of stocks. It gives you a beautiful picture of Wall Street’s demand.
When this line goes up, it tells you buyers are in control. When it’s heading south, look out below.
We’ve been overheated for nearly six weeks. The red zone threshold is 80% or greater. Back in January, we were clocking a red-hot 90% — one of the most extreme readings in years.
Back then I told you to pay attention once the BMI falls below 80%. This morning, that’s exactly what happened:
There are two important pieces of information here:
- First, a down-trending BMI indicates waning demand for stocks. Selling pressure is picking up.
- Second, and more important… Whenever we fall out of overbought, markets struggle mightily. Note the white circles and corresponding red arrows above.
Back in January, I showed you how the S&P 500 turns red in the weeks and months post overbought levels.
To take that framework a step further, let’s zero-in on small-caps.
Below, I’ve included details on all overbought periods since 2009.
From the first day the BMI falls out of overbought, here’s how the Russell 2000 (IWM) fares:
- A week later, IWM is down 1.5%
- A month later, IWM is still red at 1%
- Even two months later, small caps are off by 0.9%
Even more striking is the fact that out to two months, you have less than a coin-flip chance of a positive outcome.
Looks like this market canary is running out of air.
But to drive home how prescient this signal is, notice how striking the behavioral difference is compared to normal market action.
The chart below shows how both the Russell 2000 (IWM) and S&P 500 fare after this signal. The orange bars display how the S&P 500 ordinarily acts on average in these time fames:
Now you can understand why I rattle the cage when this rare signal fires… It’s got a great track record of predicting pullbacks.
Which brings me to the most important takeaway for YOU: Pullbacks are part of the game. They’re to be expected.
Don’t react emotionally during market gyrations… That’ll only lead to regret.
Instead, take this potential warning for what it truly is: an opportunity to buy amazing companies on sale.
I don’t know about you, but there are many stocks I’m watching that have run past my buy levels. I’d love another shot to scoop them up cheaper.
Chances are you’ll get that opportunity, and sooner than most think.
Take the time now, craft your buy list and be patient.
Use software, like TradeSmith Finance, to bring you the leading names in the market, primed to rip once the selling dries up.
The canary’s about to fall on the floor. You’ve been warned.
Now go do something about it.
Contributing Editor, TradeSmith Daily