- Multiple stock-market indicators tracked by Bank of America technical analysts worsened through the summer.
- The indicators mainly point to narrow market breadth, or the fact that a relatively small number of stocks has been supercharging the move higher.
- Shortly before the sell-off late last week, the analysts resurfaced these indicators and other risks that face investors into the fall.
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Late last week, investors were served their regular and unpleasant reminder that stocks also go down.
One of the fastest market comebacks ever was stopped in its tracks when the Dow Jones industrial average and S&P 500 saw their worst single-day declines since June.
Even before the sell-off occurred, several institutional investors had advised clients to temper bullishness with caution — especially in a year full of surprises. BlackRock, for example, shifted to a mild underweight on developed-market stocks amid the frantic rally.
The need to hedge was also not lost on analysts at JPMorgan. They warned that the tech stocks supercharging the rally were not as bulletproof as investors think.
Bank of America's technical analysts were equally flashing alarm signals from their perch in front of the chart screens. In July, they observed several technical indicators of the market's momentum that they said could delay or halt summer gains.
Near the tail end of the season, the team led by Chief Technical Strategist Stephen Suttmeier is flagging that many of these indicators have only gotten worse. The simultaneous decline in a technical indicator and improvement in price is known as a bearish divergence — and it does not bode well for the seasonally weak month of September.
"Even with a strong summer rally for US equities, there are plenty of bearish divergences across indicators moving into the worst month of the year of September," Suttmeier said in a recent note.
Besides seasonality and the technical indicators he later describes in detail, the looming presidential election is a source of uncertainty that could pose a challenging few weeks for investors.
Indeed, elections have historically weighed on stocks in their preceding months. September has been the worst month of the year for stocks on average since 1950, and October has also been weak in election years, according to data compiled by LPL Financial.
Indicators of weakness ahead
The potential dangers ahead for investors go beyond what the almanac says. Suttmeier lays out several technical indicators that did not improve while stocks ripped higher during the summer.
Of note, those related to market breadth, or the extent of participation among individual stocks during a broad uptrend, are "running on fumes," he said. The reason why is not hard to decipher: mega-cap tech companies are driving the majority of marketwide returns because investors expect physical distancing to continue driving demand for their products.
With these companies firmly controlling the market's direction, investors need to keep an eye on more obscure developments. Suttmeier has been doing so, and observed the following trends that portend more weakness than meets the eye:
- The share of stocks above their 10-, 50-, and 200-day moving averages is lower now than it was in June, when the market last experienced a drawdown of note. Technical analysts consider it bearish when a stock's spot price falls below one of these longer-term averages.
- The cumulative volume of NYSE-listed stocks — a gauge of the flow of funds into and out of the market — is lower than it was in June.
- For S&P 500 stocks, the cumulative volume has increased slightly, but still shows a bearish divergence when looked at from early June through late August.
- Two ETFs that track the credit market and help equity investors gauge the health of company balance sheets made lower highs in August. They are the High Yield Corp Bond Ishares Iboxx $ ETF (HYG) and the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD).
Despite these so-called bearish divergences, Suttmeier highlighted one bullish indicator: investors are borrowing money to trade at a faster pace than the S&P 500 is rising. The growth of so-called margin debt signals that investors have become confident enough to take on leverage, and provides a source of demand that would propel stocks yet higher.
However, the rise comes after a massive breakout in the heydey of the prior bull market. For that reason, even this potential catalyst has its limits.
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