Stock-market breadth may have already peaked with investors ‘sniffing out economic weakness’

The cumulative advance-decline line (A/D line) for the S&P 500
SPX
— a stock-market breadth indicator measuring the difference between the number of advancing and declining stocks — reached its highest level in early May, Krinsky wrote.

The A/D line trends upward when the number of advancing stocks exceeds the number of declining ones, and it falls when the number of declines exceeds the number of advances. An increasing A/D line indicates strong market breadth, while a declining line represents narrowing breadth in the stock market.

When a major stock index is rising and its A/D line is falling, it shows that fewer stocks are participating in a rally — which also suggests that the index could be nearing the end of its uptrend. 

In 1990s, the S&P 500’s cumulative advance-decline line peaked in the spring of 1998, and that peak was followed by a 22% drawdown between July and October that year, Krinsky noted (see chart below). 

“So the breadth divergence did have a consequence for [stocks] in the medium term,” the strategist said, while noting the S&P 500 didn’t see its dot-com bubble peak for another two years.

To be sure, Krinsky doesn’t call for an exact repeat of the 1998 drawdown in the stock market. However, he thinks that divergences between the S&P 500’s winners and losers can last for a long time.

The 1998 decline came amid plummeting oil prices, an Asian economic crisis, a debt default by Russia and the blowup of Long-Term Capital Management.

The S&P 500’s A/D line has declined since May, even as the index has soared to multiple record highs over the past two months. The large-cap benchmark on Friday scored its 34th record close of 2024, while the Nasdaq Composite logged its 24th all-time closing high this year, according to Dow Jones Market Data.

See: S&P 500 rally is ‘unusually strong’ in 2024. Here’s why stocks may keep rising.

Another way to look at the narrowing stock-market rally is to examine the ratio of the S&P 500 equal-weight index
XX:SP500EW
versus the typical market-cap-weighted S&P 500 index, as well as their relationship with the yield on the 2-year U.S. Treasury note
BX:TMUBMUSD02Y,
Krinsky added.

Unlike last fall, when falling 2-year yields were met with a roughly 5% outperformance of the equal-weighted S&P 500 versus its market-cap-weighted counterpart, the recent decline in 2-year yields has seen the opposite. Krinsky noted that the Invesco S&P 500 Equal Weight ETF
RSP
has been “in free fall” compared with SPDR S&P 500 ETF Trust
SPY.

“Last October, 2-year yields peaked on October 18. The RSP/SPY ratio bottomed a couple weeks later, and then rallied into the year-end as rate-cut odds increased,” he wrote. “This time around, however, 2-year yields peaked in late April, yet the RSP/SPY ratio has plunged.” 

“We think this is likely because the market is sniffing out economic weakness that will overpower the implied rate cuts,” Krinsky said. 

The Labor Department reported on Friday that while the U.S. economy added a solid 206,000 jobs last month, slightly beating expectations, the unemployment rate ticked up to 4.1% — a sign of weakness in the labor market that may pressure the Federal Reserve to begin cutting interest rates soon.

Fed-funds futures indicate a 73.6% chance that the central bank will lower its benchmark rate in September by a quarter percentage point from its current target range of 5.25% to 5.5%, according to the CME FedWatch Tool.

U.S. stocks finished mixed on Monday afternoon, with the S&P 500 up 0.1%, the Nasdaq Composite
COMP
ending 0.3% higher and the Dow Jones Industrial Average
DJIA
down less than 0.1%, according to FactSet data. 

See: This week’s U.S. inflation report could have serious implications for stocks