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A judicious examination of the price action that is observed in equity markets, with the aid of select technical analysis indicators, can often provide important signals about fundamental conditions in the US economy. In this article, I will argue that extreme divergences in the “internal” price action of US equities — as measured by market breadth indicators – constitute an early warning price signal that is warning of unhealthy sectoral imbalances that are accumulating in the US economy, with potentially serious implications for the current US business cycle expansion.
In technical analysis, the concept of “market breadth” refers to the percentage of common stocks that are participating in a given price performance trend expressed in a broad market index. A “breadth divergence” occurs when indicators of market breadth significantly deviate from the price performance of broad market indices in a given period of time.
Technical analysts consider breadth statistics to be important indicators of the health of the overall equity market and the reliability (i.e. likely persistence) of a given market trend. “Healthy” market breadth is signaled when a large number of stocks contribute to market gains — suggesting robust technical (and perhaps fundamental) underpinnings and the likely continuation of positive price trends for the overall market indexes. Conversely, when market advances are being driven by a particularly narrow group of stocks, it may signal underlying technical (and/or fundamental) weakness – a weakness that may eventually manifest itself in reversals of the “superficially” positive price trends that are reflected in the broad market indices.
A prominent example of a breadth divergence signal occurs when a broad stock market index registers an all-time high, but breadth statistics are relatively weak. This is precisely the situation of US equity markets right now: Even as equity indexes have registered new highs after extraordinarily swift gains, various measures of market breadth have registered extreme relative weakness (and narrowness) by historical standards. A very small group of stocks such as NVIDIA (NVDA), Meta (META), Amazon (AMZN), Microsoft (MSFT) and Alphabet (GOOG) have been responsible for the vast majority of the gains in the index year-to-date. Just a few examples of such indications of poor breadth are reported below.
There are dozens of statistics and indicators utilized in the field of technical analysis to measure market breadth that are currently signaling extreme internal divergences in the price action of US common stocks. In this article, I will only touch on a few:
1. While the market capitalization-weighted S&P 500 index has risen by approximately 15% year-to-date (YTD), the equal-weighted S&P 500 index has only risen by around 5% — a massive divergence in historical terms.
2. The median stock in the S&P 500 is up by roughly 4% YTD, while the index is approximately 15% YTD.
3. All US stocks outside the S&P 500 index are up by less than 3% YTD.
6. The Dow Jones Industrial Index is only up by about 4%, YTD.
7. The Russel 2000 small-cap index is up only 1.0%. Well over 50% of the stocks in the index are down YTD.
8. Only 19% of all US stocks have outperformed the US MSCI index – the worst performance in 20 years.
9. The percentage of S&P index members above their 50-day averages is less than at any other market peak in the past 60+ years.
10. At no other time in the past 20+ years has the S&P 500 index been up so much while the cumulative advance-decline line (4-week) has been in negative territory.
11. For only the eighth time since 1928, the McClellan Oscillator closed below zero for 20 consecutive sessions or more. This, despite the fact that the S&P 500 is at all-time highs!
12. It is important to note that none of these statistics or indicators – individually or collectively — constitute signals of an imminent stock market decline. However, as I will explain below, they may very constitute an early warning price signal that is indicating important fundamental problems in the US economy, and associated vulnerabilities in the US stock market.
My extensive historical studies have shown that there are very significant statistical and causal relationships between the price action of US equities (as measured by select indicators of technical analysis) and fundamental developments in the US economy.
An interesting example of this is the historically observed relationship of market breadth indicators at US stock market tops, and the contemporaneous patterns that have historically been observed in the behavior of the US economy during the late stages of its business cycle.
Specifically, during the late stages of the US business cycle, poor breadth in the US equity market has often served as an early warning signal of serious imbalances in the US economy. The correction of these macroeconomic imbalances, in turn, has often played a major role in the unfolding of business cycle recessions.
Furthermore, violations of key technical price supports (trend and level) in the broad market indices, which are accompanied swift by corrections (reversions) of price divergencies previously observed in market breadth indicators, can serve as an early warning signal of the transition of the stock market price cycle from a bull market phase to a bear market phase. The topping of the stock market price cycle, often confirmed by these signals, is often followed by a transition in the US business cycle from the expansion phase to the recession phase.
Is this a mere statistical coincidence, or is there some mechanism which suggests a causal relationship?
During the late stage of the business cycle, poor market breadth can be a signal of misallocations of resources (capital and labor) in the real economy. Specifically, poor market breadth in the midst of a booming stock market may be a price signal of disproportionate allocations of capital and labor resources to certain ‘hot’ sectors, while factor allocations toward other sectors of the economy are relatively weak.
In a “booming economy,” which is generally accompanied by a booming stock market, a skewed distribution in the allocation of capital and labor resources is often triggered by abnormal profitability (actual or expected) – and the implicitly expected persistence of abnormal profitability — in “hot” sectors of the economy. A combination of excessive optimism – often accompanied by an artificially low cost of capital — leads to malinvestments (i.e. inefficient allocations of capital and labor) during the late “boom” phase of the economic cycle. This sets the stage for a subsequent economic “bust,” or recession, wherein the various imbalances that were accumulated during the boom are “corrected.” This macroeconomic corrective process is usually characterized by plunging investment expenditures, business failures, and large-scale layoffs of redundant, unproductive or otherwise unprofitably employed personnel. These types of dislocations tend to be particularly concentrated in the previously hot sectors of the economy.
Interestingly, this pattern of the correction of imbalances in the real economy is often signaled ahead of time by analogous behavior in the price action in equity markets. Specifically, bull markets typically peak prior to the start of a recession – often many months in advance. And this peak in the stock market is often signaled by a combination of:
A) Declining prices in broad market indices;
B) A swift correction (i.e. reversion) of market internals indicated by technical indicators of breadth and relative sector returns.
In other words, during the early part of the bear market, there is often a “correction” not only in the price of broad indexes but in breadth – i.e. previously outperforming sectors fall at a faster rate than the broad indices.
In our view, the extraordinarily poor breadth that is currently being registered in the US equity market is an early warning sign of underlying imbalances that have been accumulating in the economy. Although we do not believe that a correction of these imbalances is necessarily imminent, we do think that a rather brutal corrective process is likely to figure prominently in the next business cycle recession.
Due to space constraints, in this article, I cannot go into great depth regarding the specific nature or extent of the imbalances in the US economy that I have alluded to. However, I will briefly outline a few sectors where misallocations – or “mis-timings” — are likely occurring.
1. Alternative energy. Massive quantities of investments in many alternative energy projects have outpaced the complementary infrastructure that is necessary to sustain their business models – at least within the timeframes assumed in their ambitious business plans. A clear example of this is that massive investments in solar and wind projects are outstripping the ability of the US grid to handle massive intermittent surges of electric energy that are generated by these source of energy during the daytime. Similarly, generation capacity in solar and wind is exceeding the storage capacity required to make the projects viable. These malinvestments (ill-timed) may result in business failures and loss of high-paying jobs in the sector and sectors that are linked to it (e.g. construction).
2. Cryptocurrency. Massive capital and labor resources have been allocated to various ventures that support the building out of the infrastructure that is intended to support the “cryto economy” and its hoped-for alternative financial system. However, it seems likely that a high percentage of these ventures will ultimately prove to be unprofitable, due to extreme competition, low fees and adoption rates (consumer and institutional) that are slower than investors had hoped for. If these observations prove correct, this will result in business failures loss of capital and significant layoffs of highly paid personnel in the sector.
3. Artificial Intelligence. I, personally, have little doubt that artificial intelligence will be the most revolutionary technology in many generations – perhaps of all time. However, it has become evident that there are serious imbalances that have developed in the process of building out the infrastructure and the business plans that are relying on a swift build-out of AI capabilities. For example, demand for AI services is vastly outstripping the capacity of the electrical generation and distribution infrastructure in the US and globally that is required to power data centers and other processes critical to the ramp-up of AI use. Furthermore, there is a serious shortage of raw materials such as copper which are required to build out the AI infrastructure at the desired scale and speed. The mis-timing of investments in various AI ventures will likely lead to painful losses of capital and unemployment of labor. Furthermore, there will be significant labor and capital dislocations that will be caused by the labor-saving nature of AI technologies.
For those interested in a more detailed discussion of potential dislocations in the sectors above and in other sectors of the US economy, I would encourage you to check out this Seeking Alpha blog post and video. This post delves deeply into the precise mechanisms through which sectoral imbalances tend to form in the economy, along with their sequencing. In particular, the cited post provides details regarding a very specific sort of business cycle phenomena discussed in Friedrich Hayek’s writings on this subject – one in which “monetary inflation,” via excessively easy monetary policy, sparks a distortion in relative prices between capital goods-producing sectors and consumer goods-producing sectors in the economy. These inflation-associated distortions, in turn, lead to malinvestments and imbalances in the allocation of resources between the capital goods-producing and the consumer goods-producing sectors.
Historically, the process of correcting the sorts of accumulated economic imbalances described above does not get kicked off organically. Since World War II, the timing of the process of correction of economic imbalances in the US has been linked with exogenous shocks – most frequently an oil price shock.
As regards to the current business cycle and the ongoing US economic expansion, it is our view that the US economy is currently highly vulnerable to a major oil price shock, a potential scenario which is discussed in this Seeking Alpha article. In a separate blog post, I delve more specifically into the exact causes and potential timing of a major oil price shock in the second half of 2024.
Interestingly, it should be noted that stock market price action will often provide a leading signal of a recession-triggering economic shock. In this specific case, the signal I suggest that readers be very alert to would be a drastic outperformance of oil-related equities that is coupled with a major underperformance in the sectors that have until recently been hottest (e.g. AI-oriented), and that have disproportionately driven broad equity index gains year-to-date.
During the late stage of a business cycle, a stock market environment characterized by a combination of rapid gains in broad equity indices and the achievement of new all-time highs – along with poor breadth — can serve as an early warning price signal of future problems in the equity markets and in the broader economy. In this regard, I suggest that investors pay close attention to recent statistics that document the extreme divergences in price performance between sectors, as well as the resulting extreme disparities in relative equity valuations. Investors should reflect not only on the question of whether this extreme relative price action is justified by fundamentals; they should also consider what sorts of macroeconomic conditions in the real economy the highly unusual internal price action in the stock market might be signaling. Finally, investors should be alert to price signals and news of potential exogenous economic shocks that could trigger the correction of accumulated macroeconomic imbalances and associated stock market imbalances. It is important to note that the correction of macroeconomic imbalances is unlikely to occur unless and until there is a triggering exogenous shock.
