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S&P 500 participation rate portends correction

Tuesday’s close was the second time this month the index closed within 2.5 per cent of a peak while fewer than 45 per cent of components trade above their average – a trend that almost always ends in a correction.

At first glance, the stock market in 2016 is nothing like it was last year, when winners kept winning and gains seemed to be concentrated in a handful of stocks.

Nowadays, leadership bounces around. Since January, the S&P 500 Index's strongest group has shifted among utilities, energy producers and technology companies, as investors swapped defensive shares for those that respond to economic growth.

At the same time, not all is well in the breadth department. One ominous signal that marked trading in 2015 has begun to reassert itself, a pattern in which the benchmark index hovers near a 52-week high while the proportion of stocks that are similarly elevated dwindles.

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Such divergences, measured by comparing the S&P 500 and the number of constituents trading above their 50-day moving average, have been rare since 1990 and are generally bad news for investors.

In the seven instances that occurred before this year, all but two portended further losses in the next three months, with the S&P 500 falling a median 1.3 per cent, according to data compiled by Sundial Capital Research Inc.

"This recent weakening in breadth is troubling," Jason Goepfert, president of Minneapolis-based Sundial, wrote in a note to clients. "It rarely ends well for stocks – usually, the indexes follow breadth as opposed to the other way around."

Tuesday marked the second time in the past month when the S&P 500 closed within 2.5 per cent of a peak while fewer than 45 per cent of its components traded above their average price over the last 50 days. This occurred in June and July of last year and the index plunged into a 10 per cent correction a month later as China's currency devaluation sparked the biggest selloff in four years. Stocks ended the year down 0.7 per cent for the worst performance since the 7 1/2-year-old bull market began in 2009.

Before 2015, a divergence like this hadn't shown up during the rally. The rising frequency highlights the vulnerability of the stock market to potential shocks, according to Yana Barton, a fund manager of Eaton Vance Focused Growth Opportunities Fund in Boston.

Coincidentally or not, the other time when two warning signals like this flashed within three months of each other, in December, 1999, and February, 2000, equities ended up erasing half their value over the next two years.

"Uncertainty breeds fear. All the things that we've been uncertain about, whether it's political outcome, monetary policy or the earnings recession – those are the same fear we've been dealing with," Ms. Barton said. "When you have a larger participation, it always helps because you have more names that pop up the market so you're less susceptible to potential declines."

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