Summary:
- Market breadth deteriorated all month, warning of a pullback
- Current readings suggest an oversold condition
- How the markets respond out of a potential bottom will reveal market’s true strength
- A strengthening economy and calm credit markets argue this is just a pullback, nothing more
Given the persistent deterioration in market breadth starting around the beginning of July, I began cautioning over the last couple weeks that risks for a correction were starting to build (see here, here, and here). Now that the S&P 500 and the Dow Jones Industrial Average have finally cracked, the question is how much more damage is to come?
Surprisingly, since most of the members within the market have already fallen a considerable amount starting around the beginning of July, further downside at this point may be limited. For example, the Russell Microcap Index is down roughly 8%, the Russell 2000 Small cap index is down just under 7%, while the large cap and megacap indexes are down less but contain fewer members.
Source: Bloomberg
For this reason simply looking at how oversold the large cap S&P 500 is may be misleading and a bottom may be closer than most believe. One of my favorite indicators I use for spotting intermediate-term bottoms in the market is a breadth indicator that measures the percentage of members with a MACD line greater than zero. When the number dips below 30% we are at or near a bottom. Looking at the S&P 500 shows the indicator only close to neutral levels at its current 59% reading as most of the damage in the markets has been in smaller marketcap issues.
Source: Bloomberg
The NASDAQ and its 2500+ members are pretty close to the 30% mark with its current 38% reading and shouldn’t be too far off from a bottom.
Source: Bloomberg
An examination in small cap stocks in the Russell 2000 shows a more oversold condition with its 30% reading.
Source: Bloomberg
Given the weakness started with small caps and that they are close to an intermediate-term oversold condition, stabilization in the Russell 2000 would likely help arrest the current decline. What will be crucial to scrutinize in the days and weeks ahead is the character of any recovery in the markets. If we see risk assets like small cap stocks and junk bonds only rally marginally from an oversold condition, then we are likely setting up for another leg down after an oversold bounce. However, if we see strong inflows into the stock market and risk assets rally at a brisk pace, then the recent decline will only have helped work off an overbought and over bullish condition, which is a healthy sign.
Even if we do have another leg down, the probability that equity markets have peaked and moved into a bear market seems low. Economic momentum continues to build from a weak first quarter and the momentum coming from the second quarter with the US GDP print of 4% real annualized growth appears to have spilled over into the third quarter as we’ve seen 86% of incoming leading economic indicators accelerate over their June levels.
Source: Bloomberg
The bullish breadth of economic momentum is clearly present across the nation as well with 92% of the 50 US states expected to see economic growth over the coming six months as seen by the Philly Fed State Leading Index:
Source: Bloomberg
The sea of green shown for June is a much stronger picture than what was seen three years ago as the Economic Cycle Research (ECRI) was about to make their erroneous recession call on September 30th of 2011 (click for link).
Source: Bloomberg
We also haven’t seen any major deterioration in the credit markets to indicate a bull market top is forming.
Source: Bloomberg
As mentioned above, it will be important to gauge the strength of the markets character out of an oversold condition. Should breadth on any ensuing rally prove weak and the riskiest areas of the market like small cap stocks and junk bonds not attract investor capital, then the corrective period we’ve recently entered will likely persist. The converse is also true: if breadth improves and riskier assets perform well we should see the markets push higher and the S&P 500 possibly breach the psychological 2000 barrier. Time will tell.
