What the Stock Market Needs is Mouthwash

The stock market has some pretty bad breadth.  No, not bad “breath,” but bad “breadth.”  I’ll explain in an analogy and then nerd-out afterward.

This past weekend, we took advantage of our seemingly never-ending downtime to watch an old classic in “Swiss Family Robinson.”  Toward the end of the movie, the pirate general leads an attack on the family with his troops marching angrily at his side.

However, the family has another plan and releases an onslaught of traps, falling rocks, and homemade coconut grenades.  While the general relentlessly continues to push forward, eventually his troops give up, and the entire pirate army runs away.

To bring this analogy together with what we’re seeing in the stock market today you first have to think of the entire pirate army as the S&P500.

Next, think of the pirate general as Microsoft, Apple, Amazon, or Google.

Now, think of the troops as all the other companies within the stock market, such as Alliance Data, Under Armour, Gap, Nordstrom, Kohl’s, H&R Block, Marathon Oil, Ralph Lauren, Alaska Air, Halliburton, Wynn Resorts, and Hanesbrands.

I want you to look at the chart below and notice that Microsoft, Apple, Amazon, Google, and Facebook make up well over 20% of the S&P500 index, which also happens to be a higher percentage than the top five companies on the S&P500 at the peak of the market during the dot-com bubble and subsequent market crash:

The lesson here is this:  When the stock market gets decimated, you can’t always see what’s going on behind the scenes.  What we’re experiencing is a small percentage of companies that are performing pretty well, making the stock market look as if “all is well and rosy” when in reality, a good portion of the rest of the market continues to rot underneath the guise of a handful of stocks.

So, as the pirate general continues to push forward, he stops to turn around, only to find that all his troops have retreated.

What makes me think this?  Below is a metaphorical x-ray of the stock market.  This is just one set of several indicators I analyze each day.  This one is one of many aimed specifically at observing whether or not the troops are still running with the generals:

• The top pane is simply a chart of the S&P500 with its 50-day trend (blue) and 200-day trend (Red)
• The next one down is the percentage of large company stocks within the stock market that are currently above their 200-day trend (27.72%)
• The next one is the percentage of mid-sized company stocks within the stock market that are currently above their 200-day trend (15.50%)
• Lastly, the one at the bottom is the percentage of small-sized company stocks within the stock market that are currently above their 200-day trend (13.14%)

In other words, when you look at the 1,500 stocks that are included in this “x-ray” above, more than 80% of them are currently below their long-term trends.

To use a different analogy, think of the major market indices (such as the Dow, S&P500, or the NASDAQ) as the outside, observable portion of a nurse’s patient.  Now think of the internals as the heartrate, blood pressure, EKG, and other vital signs that require more testing and tools.

There have been countless times in the past when a patient looked fine, but after running some tests, bloodwork, and a CT scan, we discover that a potentially fatal disease lurks beneath the surface.  To close out the analogy here, the “health” of the market is not “skin-deep!”

The more the stock market rises while its internals struggle in the basement, the higher the likelihood we prematurely discharge the patient while its vital signs suggest it should remain in the hospital… and bad things can happen if we send an unhealthy patient home before they’re ready to leave.

I apologize for the poor image quality below, but I had a hard time finding a high-resolution version of this classic hypothetical chart.  What you see below is a conceptual look at how the market typically crashes.  It peaks along with undying enthusiasm, falls throughout a feeling of panic, and bottoms on emotional discouragement.

Here’s the same chart with an overlay (in blue) with the current market.  Now, this time doesn’t have to follow the average movement of the market going forward, but as Mark Twain once said, “History doesn’t repeat itself, but it sure does rhyme.”

The people at Sentimentrader say this crash is on “hyperdrive” because of the insane volatility we’ve been experiencing in the stock market.  As you can see below, in the first quarter of 2020 alone, the S&P500 has experienced more days where it’s been up or down by more than +/- 1% than it did throughout the entire year during the 2008 crash.  Now that is some crazy volatility.

Nerds’ Note:  In the short-term, the stock market has risen for just over three weeks while volume has declined.  In a healthy market, we’d see volume increasing as the market rises, not the other way around.  In addition, the S&P500 is reaching a “Danger Zone” where several different potential overhead “ceilings” of resistance are coming into play (for more details on this, see my most recent VIDEO update.)

In the middle-pane above, you can see how recently, more stocks are coming back below their 20-day trends while the market has gone – again, more evidence that a small handful of “pirate generals” are leading the move while their troops run away from the battle.  Lastly, in the bottom-pane above, momentum is also making its way into the “Danger Zone” level where, if the market is going to peak and head lower, it would typically do so within this range.

In an article by Jason Zweig, published in The Wall Street Journal on Friday, Charlie Munger (Warren Buffett’s right hand man) explained that this environment is “like being the captain of a ship when the worst typhoon that’s ever happened comes.  We just want to get through the typhoon, and we’d rather come out of it with a whole lot of liquidity.”

He went on to say that, “One of the keys to great investing results is sitting on your ass,” which means being conservative and doing nothing during times like this and then buying with “aggression” when the time is right.

I continue to agree with people like Munger who think this way.  I personally don’t want to attempt to be a hero and try to catch a falling knife.  I’d rather wait for the knife to fall to the ground, come to rest, and then pick it up.

There will be plenty of opportunities to participate in a healthy uptrend when it appears.  But the market is guilty until proven innocent, and the weight of the evidence still suggests that there is a lot of pain ahead before we can say that we’re out of the woods.

Till next time…

Adam