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While the S&P 500 his on an impressive string of new highs, a number of them have come on questionable breadth.

When it comes to analyzing the quality of a stock market rally, we are big on breadth, or the internals, of the market. The more participation there is on the part of all stocks, the better the foundation to support the rally. If the rally is reliant on only a relatively few large stocks, it only takes a few stocks breaking down to undermine the advance. On that basis, the quality of the post-August rally has been, for the most part, superb. The validity of that assessment over the past few weeks, however, has come into question due to an odd string of new highs.

Specifically, the S&P 500 has recorded 5 all-time highs over the past 10 days. Interestingly, 3 of those have occurred on negative NYSE breadth, i.e., more NYSE declining stocks than advancing stocks. If that seems unusual, it’s because it is. Looking back in our database to 1965, we find only 3 other 2-week stretches containing at least 3 new highs occurring on negative breadth:

3/20/1995

6/20/1997

12/14/2010

The concern with these clusters of negative breadth new highs is that the rally participation may be starting to wane. Thus, despite the new highs in the average, the market may be getting more vulnerable.

Looking back at the prior clusters, did the performance of the S&P 500 bear out that concern? Well, the sample size is a minuscule 3 -- but the evidence would clearly suggest no. We won’t present the full performance table following those 3 precedents, but we’ll say that 2 months later, the S&P 500 was higher by at least 4.5% each time. Furthermore, the worst 6-month drawdown of any of the 3 events was a mere -2.4%.

So, that puts some of the concern about weakening internals to rest -- but, again, only based on 3 occurrences. We’d prefer a larger sample size in order to place any real measure of confidence in the data. If we relax the parameters a bit and look at clusters of just 2 negative breadth new highs within a 10-day span, we come up with 14 unique occurrences in 52 years, prior to the current one.

So does this larger sample size add validity to the concern about weakening internals? As the chart reveals, a number of the occurrences certainly took place in the vicinity of intermediate-term, or even cyclical, tops. But what about in aggregate? Is the signal a consistent enough warning to warrant our attention? Let’s check out the full post-event performance history:

Overall, the S&P 500′s performance following these events is pretty solid, with slightly above average median returns over most time frames. However, it has been anything but consistent. There were, again, a handful of events, e.g., 1968, 1979, 1980, 1998, 1999, that preceded sizable drawdowns in the intermediate-term -- or even full-on bear markets.

So, is there any distinguishing market characteristic that delineates the good episodes from the bad? And on which side does our present case fall?

As you know, we are generally able to isolate a condition or two in these studies that has led to a consistent pattern of behavior in the market. This time, however, it was a struggle to find such a pattern. No matter which way we parsed the data, the results seemed to come up mixed. 

About the only pattern we identified, and a loose one at that, was that the index’s short-term performance often foretold of its longer-term fate. For example, each of the 4 events that saw the S&P 500 lower 1 week later were also down 3-6 months later. Besides that pseudo-trend, the results seemed to genuinely be of a random nature. Eventually, we stopped looking for a “magic” indicator delineating the good episodes from the bad, as our efforts began to head dangerously down the data-mining path.

So what’s the bottom line here? This study is a difficult one to put much stock into, so to speak. Multiple S&P 500 new highs occurring on negative NYSE breadth in a 2-week period have led to mixed results, though, more good than bad. Perhaps the most instructive thing we can say is that these events have not been a consistently accurate warning of weakening internals and a vulnerable market.

We certainly would not consider this development to be a bullish signal. However, if you want to find something to worry about when it come to the stock market, there are much better candidates than this one.

This is a free look at the “all-access” versions of our charts and research that we post daily (among much more) on our new site, The Lyons Share. TLS is currently running a 30th anniversary 1987 Crash Commemoration SALE, offering a discount of 22.6%, or the equivalent of the Dow’s 1-day drop 30 years ago. The SALE ends October 22 so considering the discounted cost and a potentially frothy market climate, there has never been a better time to reap the benefits of our risk-managed approach. Thanks for reading!

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Ted Spread Highest Level In Seven Years

You may have seen warnings about the Ted Spread in recent days, along the lines of this blurb from The Wall Street Journal:

A measure of stress in financial markets, whose alarm bells heralded the 2008 financial crisis, just hit its highest level in over seven years.

Spikes In Ted And Stocks

The last three times the Ted Spread spiked was it better to be buying stocks or selling stocks? Recent spikes in the Ted Spread have occurred during sell-offs in the stock market. However, the peaks in the Ted Spread occurred just prior to sharp rallies in the S&P 500.

New Regulations And The Ted Spread

Another factor to consider is the regulatory impact on the ongoing utility of the Ted Spread. From The Wall Street Journal:

But don’t worry. It turns out the so-called Ted Spread might be dead, an unlikely casualty of the recent changes in U.S. money-market regulation… The U.S. Securities and Exchange Commission’s new rules for money-market funds come into effect in the middle of October. They are designed to stop rapid outflows during periods of panic and include abandoning a fixed $1 share price and allowing these funds to impose fees on shareholders who withdraw assets. Funds can also suspend redemptions temporarily.

The Bigger Picture

The recent spikes in the Ted Spread did occur during periods of increasing fear in the equity markets. Therefore, as always, we remain open to all outcomes over the coming days and weeks, including bearish outcomes. This week’s stock market video covers a very rare shift that recently occurred in the financial markets; what could have caused the shift and what does history tell us about the present day stock market?

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

How Helpful Is The Ted Spread?

Indicators that have strong and consistent correlations to the S&P 500 can be helpful. As shown below, the correlation between the Ted Spread and the S&P 500 looks like an 8.0 magnitude earthquake on the Richter scale. Sometimes stocks go up when the Ted Spread goes up; sometimes stocks go down when the Ted Spread goes up.

Does Volume Complement or Contradict Bullish Analysis?

An August 19 analysis outlined a long-term bullish signal for stocks that has occurred only ten other times in the last thirty-five years. Have we seen any other long-term signals in recent weeks? The answer is yes.

A Trend Change in Up/Down Volume?

The chart below shows up/down volume (1996-2010) for the NYSE Composite Stock Index, along with its 50-week moving average (thick blue line).

Notice how all-things-being equal, the probability of bad things happening increases when the 50-week moving average is flat or negative (see orange and red arrows below). Conversely, the probability of good things happening increases when the 50-week moving average turns back up in a bullish manner (see green arrows below). The S&P 500 is shown at the bottom of the image below for reference purposes.

Has The Line Turned Back Up In A Bullish Manner?

The answer to the question above is yes. In simplified terms, it appears as if volume patterns have shifted from favoring declining issues earlier in 2016 to favoring rising issues currently.

A Foolproof Signal?

Since there is no such thing as a foolproof indicator or signal in the financial markets, the recent bullish shift in up/down volume assists us with probabilities. As long as the slope of the 50-week remains positive, the odds of good things happening will be higher. With Yellen’s Jackson Hole speech coming Friday, the market will be processing some important new information in the coming days.

Long-Term Means Long-Term

An index of the largest stocks in the market just formed an apparent triple top -- but is it a legitimate concern?

One topic on most market strategists’ minds (whether they admit it or not -- we do) is has the stock market topped? Specifically, has the post-2009 cyclical bull market topped? And one consideration for many (whether they admit it or not -- we are guilty, at times) is does it look like a top? Now that should probably be very low on the "top” checklist. Indeed, we have a set of metrics and indicators which are much more accurate in assessing the likelihood of a top (of some magnitude) than the so-called eyeball test. However, it is a tempting exercise to engage in as it involves all of glancing at a chart in order to form an opinion.

In reality, identifying a top is an extraordinarily difficult proposition -- and for the most part, a fruitless one. How many tops are there in a cycle? Yes, just one. And yet, market participants want to continuously label each hiccup along the way a potential top (guilty again, to an extent). Our advice is to manage your process in real-time (we believe in an active risk-managed approach) without regard for imponderables such as trying to guess a top.

Besides, in our view, accurately identifying a top by merely observing its chart pattern has become more and more difficult in recent years. One likely reason is the recent proliferation of technically-oriented traders and investors. Once a critical mass is reached in terms of eyeballs, conventional patterns and interpretations cease to reliably persist. If everyone is watching the same stimuli, after all, how can it possibly work? Heaven knows the majority of traders are not successful in this business.

One such supposedly “traditional” topping pattern can be seen in today’s Chart Of The Day. The security is the Rydex Russell Top 50 mega-cap ETF (ticker, XLG). The Top (no pun intended) 50 index comprises the 50 largest stocks in Russell’s entire universe. The pattern that we are highlighting is a potential “triple top”. As the name implies, the pattern consists of three peaks in very close proximity. TA textbooks would suggest this is a very bearish pattern and possibly setting the stage for a serious decline.

In reality, we could probably count on one hand the number of triple tops we’ve seen actually pan out of late (we’ve seen other veteran technicians express the same view). Yet, the pattern continues to draw significant attention. Whether its due to a successful (long ago) track record, or merely the alliteration of its name, the triple top is still a popular call-out among market watchers. However, again, we’ve seen the pattern eventually fail far more times than not, i.e., a failure here meaning the XLG would negate the triple top by breaking out to new highs.

Perhaps the closest recent potential example to panning out was the tri-decadal triple top in the Value Line Geometric Composite (see our 5/8/2015 post). However, even that version saw the index temporarily break out following the third “peak” before dropping back.

And therein lies a possible scenario that would “sort of” satisfy the triple top and forecasts for a top in the XLG. Because, if there has been any version of a topping pattern in recent years that has been somewhat predictable and reliable, it has been the false breakout. This goes back to the notion of everyone watching the same stimuli. In those cases, the market will generally do whatever will harm the most people.

So what are the odds that the Russell Top 50 has formed a bull-killing triple top? Better than spotting a unicorn, though, not by much as they are probably just about as rare. So while the triple top can’t be ruled out, we would certainly not be surprised to see new highs in the XLG before the ultimate top is in -- even if it is almost immediately following.

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Micro-cap stocks have suffered a key breakdown relative to mega-cap stocks, suggesting a “risk-off” shift on the part of investors.

One of the themes in the stock market this year has been the under-performance of small-cap stocks -- and conversely, the out-performance of large-caps. Today’s Chart Of The Day is a caricature of that theme as it involves a comparison between the very smallest stocks, micro-caps, and the very largest, mega-caps. Not surprisingly, the micro-caps have taken it on the chin this year relative to the mega-caps. In the past few days, however, the deterioration in micro-caps has accelerated, reaching a dubious milestone.

As measured by the ratio between the iShares Russell Micro-Cap ETF (IWC) and the Rydex Russell Top 50 ETF (XLG), micro-caps are at a 3-year low and have broken their uptrend that has been in place since 2009.

“So what?” you may say. “Something always has to be leading and something else has to be lagging” That is true. However, it is more bullish for the broad stock market when the smaller, more speculative issues are leading the way. When that is the case, it can be a sign of relative comfort and willingness to take on risk on the part of investors. Money will flow into stocks more readily under those circumstances.

However, when the micro-caps are lagging and the largest, seemingly most secure stocks are leading the way, it can be a sign of apprehension by investors to take risk. Money is less likely to find its way into the stock market under those “risk-off” circumstances.

Sure, we all know that these divergences can persist for some time. 2015 is a testament to that. Eventually, though, the small-cap weakness tends to leak into the broader market, including the large caps. The concern at this point is that the divergence has already persisted for some time. In fact, the micro-cap:mega-cap ratio topped back in March of 2014. So we are approaching 2 years of lagging small caps. At this point, the market segments that have thus far been able to avoid similar weakness are likely on borrowed time.

So, does that mean go out and sell all of your strong-performing large-caps also? Not at all. In fact, the relative weakness in small-caps is due, naturally, in part to the healthy action in the large-caps. We are strong proponents of relative strength, i.e., buy what is going up. Therefore, if you are going to own stocks right now, the large-cap space continues to be a place that warrants an over-weight allocation.

What about the strong seasonal pattern for small-caps? That is certainly a potential factor. As we noted in a few posts earlier this month, December has been exceedingly bullish for small-caps, particularly following an intra-month drawdown. Even if it wasn’t a seasonally positive time of year, a mean-reversion bounce by the small-caps in some fashion would not be too surprising.

However, we will go back to the topic of relative strength. What happens in the very short-term is highly unpredictable. However, concentrating on longer-term relative strength when allocating investments has worked best for us. Buying a stock in a long-term uptrend provides greater margin for error than trying to catch a falling knife. Even if you do not time your purchase ideally, you are swimming with the tide and are more likely to eventually see the position go your way.

The trend is your friend, in other words. And the trend continues to be strongly in the favor of mega-caps and against micro-caps. And while there may be bouts of mean-reversion in the small-caps’ favor, a durable shift their way is unlikely at this time. On the contrary, given the recent relative breakdown, an acceleration of the current trend away from micro-caps may even be forthcoming.

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Muhammad Ali photo from Daily Mirror.

More from Dana Lyons, JLFMI and My401kPro.

Mitch’s Mailbox, Your Portfolio Questions Answered

Fort Meyers, FL asks...

I received an inheritance and was going to invest, but the market’s volatility and downward turn has me concerned so I’m waiting. Is that a good idea?

Great question - and, an important one given the potential impact one's actions, or inaction, can have on long-term returns.

In August 2015, when the market plummeted, this question arose for me daily - and, the market’s recovery since has essentially answered the question.

If you have conviction about the market’s direction over the next 12 months (bull or bear), and the money you’re thinking about investing is for the long-term, then to me it makes sense to put it to work. Trying to time the market is a mistake, and odds are you’re going to get it wrong.

The logic behind ‘waiting to invest’ during downside volatility is flawed. By definition, it means the investor is waiting for prices to recover (meaning stocks are more expensive) before they feel comfortable enough to buy. That would be like skipping a sale at a department store in favor of waiting for prices to go back up – who is going to do that?  Not me!

The terminology that best describes this mindset is “recency bias.” It refers to an investor’s tendency to think that the trends and patterns we observe in the recent past will continue in the future. In the case of this past August, ‘recency bias’ convinced some investors that downside volatility would persist for several weeks or even months – and that led to cold feet. But, the market doesn’t work that way. Typically, what happens in any given day does not imply what will happen the next. That’s why it’s so important for investors to focus on the trendlines, not the headlines.

For long-term investors, there is also the fact that missing the best days in the market can significantly impact your total return over time. In a 20-year period from 1995 through the end of 2014, an investor that stuck with stocks (S&P 500) throughout could have expected a $10,000 investment to grow to $65,543 – a 9.85% annualized return. But, if that investor missed just the 10 best days in the market (which often happen very close to the worst days that spook investors), the $10,000 investment would be worth much less – growing to only $32,665. Miss the 40 best days, and you actually lose money.

So, when it comes to trying to time the market, remember what that could cost you. I don’t think it’s worth it. This is especially the case if you have long-term growth objectives - in that scenario you are almost certainly better off spending as much time invested as you can. The numbers above prove as much.

Applying this long-term approach to your current, or prospective, money manager is also important. Knowing how a manager fared through both up and down markets is key information as you assess potential working relationships. There are nine other questions which we suggest asking a prospective money manager (many of which you likely have not thought of).  Download the guide now -- it's annotated with responses to look for from these questions.  We hope this helps!

Download FREE Guide:  What to Look for in a Money Manager

Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. Zacks Investment Management, Inc. is a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts an investment manager for individuals and institutions. Zacks Investment Research is a provider of earnings data and other financial data to institutions and to individuals.

We have been hearing a lot of complaints about how weak breadth has been, how only a few stocks are pulling the indices higher.  Whether bad breadth will ultimately be a problem or not remains to be seen. You have to keep an open mind that maybe more stocks will start to participate in the future, it doesn’t always end badly. The image below tells you the whole story.  The mega-cap names that have a larger effect on the SP500 have outperformed their little brothers on a 1, 3, 6, and 12-month basis. The lower cap names are all lower in every time-frame. According to Finviz, there’s 21 mega-cap names, 571 large caps, 1041 Mid caps, 1621 Small caps, 1229 micro caps, and 599 nano caps.  When you take the breadth of the entire market and plotted against the SP500 you more than likely will see divergences. It’s not fair to compare 4,490 stocks not in the SP500 to the SP500.

Maybe it’s not too late get reacquainted with the smart money index of the 90’s, $OEX. The index is composed of the largest U.S. companies in the world.

See How I Translate My Tweets & Blogs Into Actual 3rd Party Verified Trades

We have mentioned the put/call ratio of open interest on S&P 100 (OEX) options a handful of times over the past 6 months or so. The reason is that this historically “smart money” indicator has been flashing warning signs off and on during that period. On March 3, we posted our most recent update on the indicator as it was on an unprecedented string of bearish readings. The stock market peaked simultaneously and has drifted sideways in the 6 or 7 weeks since. The bearish OEX put/call readings have not relented, however. In fact, the bearishness has accelerated. Even so, we had not intended to dedicate another post to this indicator so as not to be redundant. However, the readings over the last few days warrant an update as they have become so extreme, they stick out on the chart like a sore thumb -- kind of like Wilt Chamberlain’s 4th grade class picture.

As a refresher, we typically scan for extreme readings in put/call ratios in the options market in order to fade them. For example, when a certain put/call ratio reaches what has historically been a high extreme, it is often a “buy signal” in that market as it indicates that traders have become too fearful or bearish due to their preference for puts relative to calls. One market that has historically been an exception to this “contrarian” rule is the OEX options market. For whatever reason, these traders have, more often than not, been correctly positioned at market extremes (i.e., high put/call readings near market tops). And while volume in the market has dropped significantly in the past few decades, its non-contrarian status has not seemed to change.

Since 1998, the put/call ratio on open interest in OEX options has been considered extremely elevated when it has risen above 2.00. From 1998 to 2011, there were just 6 days when the ratio got as high as 2.00. Each of those days either came in the vicinity of a significant market top or at least presented extremely limited upside in the intermediate-term. In the second half of 2014 alone, there were 8 readings. And 2015 has ratcheted up the frequency of such readings to a whole other level. There have now been no less than 34 readings above 2.00, all coming in the past 2 months.

And it hasn’t just been the frequency of the readings, but the magnitude as well. Before a week ago, the highest level of the OEX open interest put/call ratio since 1998 was 2.31 in November 1999. The past 2 days have seen readings of 2.77 and 2.79!

It isn’t difficult to spot the “Wilt the Stilt” readings on the far right of the chart, nearly 0.50, or 20%, higher than any other reading on record. And based on historical readings above 2.00, this would appear to be a warning sign. Consider the performance of the S&P 100 following other readings above 2.00 from 1999 to 2014 (it is obviously too early to judge 2015′s readings and, additionally, the 2014 readings do not have a 1-year forward return or, for some, a 6-month return.)

Obviously, considering these returns came during a 16-year period of historically below-average returns, it’s not surprising to see them somewhat depressed. However, the negative average return out to even 6 months (-0.02% to be exact) is noteworthy. Furthermore, considering the substantial drawdowns suffered in the aftermath of several of these readings, the above returns may actually understate the risk following put/call readings above 2.00. Consider the dates of the occurrences prior to 2014, including November 1999, June 2003, May-July 2007, May 2011 and January 2012. Of those, only the 2012 occurrence did not result in either sideways action for 3 months (2003) or a major selloff (each of the others).

Of course, we cannot dismiss the occurrences since the beginning of 2014. Obviously, they have not (yet) resulted in anything close to the aftermath of most of the prior occurrences. However, even they have shown to be somewhat effective in forecasting at least short-term weakness. Of the 24 put/call readings over 2.00 since the start of 2014, only 5 really showed gains 1 month later.

The obvious question, pertinent to many of our posts over the past 12 months or so, is whether the recent market regime is here to stay or whether it is the outlier. As we stated in a previous post, we would argue that is is too soon to pass judgement on the indicator’s contemporary relevance on the intermediate to longer-term time frame. At a minimum, based only on the results over the past 8 months, we can accept that elevated readings of the OEX open interest put/call ratio suggest merely short-term negative connotations for the market.

However, given its more extensive history as a warning sign as well as the current “off the charts” magnitude of the indicator’s readings, we can’t help but wonder if there will eventually be longer-term ramifications as well.

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“Wilt Chamberlain 4th Grade Class” photo by Unknown.

More from Dana Lyons, JLFMI and My401kPro.