How to take the market’s pulse

Four key models can help gauge what’s happening in the market beneath the headline numbers.

Breadth

Market breadth measures the number of companies in the index that are currently trading above their 50-day moving average (DMA). Those above their 50-DMA are believed to be on a bullish trend while those below are bearish. We become concerned when market breadth and the market diverge.

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Currently, we are seeing market breadth decline, meaning fewer companies are in a bullish trend, while the overall market remains range bound. In other words, market leadership is narrowing. Only 54% of the S&P 500 constituents are in a bullish trend, down from over 80% at the beginning of April. Declining breadth is a concern. It may reverse, but for now it’s troubling.

Consumer Stocks

This model tracks the relative performance of the S&P 500 Consumer Discretionary sector against the Consumer Staples sector and is best described as a measurement of investor risk aversion. The premise is Consumer Discretionary stocks, which include retailers, media, services, durables and autos are considered a higher beta sector that reacts more to optimism.

If investors are optimistic on the market or the economy, this is a sector that will see more bids. Consumer Staples are the opposite. Food, beverages, household products are all items that people buy regardless of what is happening in the economy. Staples are also viewed as a sector that may be safer during periods of market volatility. Using the index’ 200-day moving average as a trigger for changes in direction, this model turned bearish on the broader market earlier in April. While it does give false signals, it has a good record of warning of bigger changes in market direction.

Risky vs. Less Risky

This expands on the Consumer Stocks model to incorporate other sectors and measures investor changes in risk aversion. It contrasts the relative performance of riskier and less risky sectors to get a feel for what is moving the market.

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Riskier sectors include Technology, Industrials, Materials, Energy and Consumer Discretionary. Less Risky sectors include Consumer Staples, Health Care, Telcos, Utilities and Financials. As the Consumer Stocks model may be influenced by a few names (autos with recalls, for instance), the Riskier vs. Less Risky model is broader. The good news is this risk aversion measure remains fairly neutral.

Size

With the general perception that smaller-cap companies are riskier, the relative performance of large- and small-cap indices provides additional insight in market breadth/leadership and risk appetite. After a number of years of outperformance, small caps have been underperforming large caps over the past few months. Again, it may be overdue, but it’s still not a healthy sign for the overall market.

Investment Implications

These indicators suggest an increased likelihood that we may see a more substantial market pullback in the near term. Signals can be false, of course, but the number of warning signs is worth taking note of. Fortunately, our longer term analysis and models continue to remain in the bullish camp for both the economic cycle and equities. As a result, we would be buyers of weakness.

Gareth Watson is the Vice President, Investment Management & Research at Richardson GMP in Toronto. This team of research experts is responsible for monitoring and interpreting economic, geo-political situations, current market environments and trends. @Gareth_RGMP