Composite Breadth Model Takes a Turn, S&P 500 Breadth Deteriorates Further, Bond Spreads Widen to Multi-month Highs (Premium)

Weakness in mid-caps and small-caps is finally taking its toll on the broader market and the Composite Breadth Model. We are also seeing S&P 500 breadth indicators deteriorate and dip towards bearish levels. Even though the S&P 500 represents “large-caps”, keep in mind that the top 10 stocks account for 31.4% of the index, the top 50 account for 56% and the top 100 account for 70.5%. This means the remaining 400 account for 29.5% and many of these are struggling.

The $1 million question is: Will weakness in mid-caps and small-caps pull down large-caps? Or will large-caps hold up as money rotates into the biggest and the safest? Watch the S&P 500 Trend Model and the SPX 5/200 day SMA cross for clues. These two are holding up still, but the other three inputs in the Composite Breadth Model are bearish, which means the model is net bearish (-1).

We are also seeing a fairly strong widening in yields spreads and the Junk Bond ETF hit a 52-week low. Combined with a bearish Composite Breadth Model, risks in the equity market are now considered well above average and this argues for some serious selectivity. Correlations typically rise when the market turns down and there are often few places to hide. This is also why raising cash levels makes sense in a bear market environment. It has probably been a good year for most of us and might be a good time to just close out, enjoy the holidays and return in 2022.

This is not the normal Thursday commentary because the publishing schedule was accelerated this week. I covered the broad market environment and intermarket ETFs on Monday (TLT, GLD, DBE, UUP). There were also commentaries on Tuesday and Wednesday covering ETFs. Check the main analysis page for details.

Composite Breadth Model Turns Bearish

The next chart shows the Composite Breadth Model in the first window and the five inputs in the other windows. The CBM turned negative (-1) on December 1st and this means three of the five inputs are bearish. The S&P 500 Thrust Model, S&P 1500 Thrust Model and S&P 1500 Trend Model are bearish. See the red -1 on the right side of the indicators. The bearish signal in the S&P 1500 Trend Model reflects the weakness we are seeing in mid-caps and small-caps. For the two bullish inputs, the S&P 500 Trend Model is bullish (green 3) and the 5-day SMA remains above the 200-day SMA for the S&P 500 (+7.14%). These two inputs show us that large-caps are holding up better.

The S&P 500 and S&P 1500 Thrust Models are the most sensitive and the most easily swayed. These two turned bearish because downside participation surged over the last few weeks, especially with small-caps and mid-caps. The 10-day EMAs for S&P 500 and S&P 1500 Advance-Decline Percent all plunged below -30% on December 1st and this represents a bearish breadth thrust. At this point, the onus is on the bulls to prove the bears wrong. Thus, an upthrust in short-term breadth is required to turn one of these models bullish again.

The charts on this page are part of the "Market Regime" page, which is updated every Friday. Today's update is a day earlier because market conditions warrant.

Note that the S&P 500 Trend Model is not far from a bearish signal. The chart shows SPY in the top window and the five indicators for the model. SPX %Above 200-day SMA and SPX %Above 150-day SMA bounced in October, but did not exceeded their August highs and turned sharply lower the last few weeks. These two have been deteriorating since summer. A move below 45% and 35% respectively would turn these two bearish (red lines).

The lower windows show SPX High-Low Percent dipping to -9.4%, which is the lowest level since March 2020. There were 51 new highs and 4 new lows on Wednesday, the most new lows since March 2020. Downside participation is expanding and a move below -10% would turn this indicator bearish. Note that the model turns bearish when three of the five indicators have bearish signals. The lowest window shows the 10-day EMA of Advance-Decline Percent plunging below -30% for the first time since – you can guess – March 2020. This is a bearish breadth thrust.

The breadth charts, yield spread charts and Fed balance sheet are part of the “Market Regime” page, which is updated every Friday. This commentary expands on these charts because of recent developments.

S&P 500 Thrust Model Turns Bearish

Since we are covering the Composite Breadth Model in detail, I will go over the S&P 500 Breadth Thrust model. There are three indicators: SPX %Above 20-day SMA, SPX %Above 50-day SMA and the 10-day EMA of Advance-Decline Percent. There is a fine line between healthy oversold and a bearish breadth thrust. SPX %Above 20-day is oversold when below 20% and above 10%. A move below 10% shows serious downside participation that tips the balance towards the bearish. SPX %Above 50-day is oversold when below 30% and above 15%. A move below 15% shows serious downside participation that tops the balance.

With an increase in downside participation this week, %Above 20-day SMA plunged below 10% and the 10-day EMA plunged below -30%. %Above 50-day SMA is still bullish (green), and the Model is at -1 (2 bearish signals and 1 bullish signal). The thrust models are part of the Composite Breadth Model, but they alone cannot turn the CMB bearish. At least one trend model needs to turn bearish as well (or the 5-day SMA of SPX needs to cross below the 200-day SMA).

Yield Spreads Widen to Highest Levels since March

Yield spreads are part of the Market Regime page below the bond market is more sensitive to financial market stress than the equity market. I measure the stress levels in the bond market using yield spreads, the difference between the yield on a corporate bond and US Treasury bonds. Corporate bonds are riskier than Treasury bonds and the yield spreads widen when the bond market sees more risk in corporate bonds. AAA bonds are the highest rated investment grade corporate bonds, BBB bonds are the lowest rated investment grade bonds, junk bonds are risker than BBB bonds and CCC bonds are the lowest rated junk bonds (the junk of the junk).

Overall, these yield spreads remain at low levels (narrow) by historical standards (10+ years). Short-term, however, we are seeing quite the uptick as these yield spreads widened over the last few weeks. These spreads are wider (higher) than in the summer and the bond market is getting stressed.

The first charts shows the AAA and BBB spreads moving sharply higher since November 8th, which is when the Russell 2000 ETF (IWM) peaked. This upturn coincides with a downturn in IWM and SPY followed with a downturn over the past week. It is interesting to note that the yield spreads actually narrowed (blue lines) when SPY corrected in September and fell 5% from its high. SPY is currently down 4.1% from its 18-November closing high and the bonds spreads are sharply higher. This is recipe for volatility (at best) and/or further weakness.

Junk bond spreads also ticked up in November and hit their highest levels since the first quarter. Note that the Junk Bond ETF (_JNK) peaked in September and hit a 52-week low this week. If charting at StockCharts, make sure you precede the symbol with an underscore to chart without dividends (monthly payouts). I am only interested in price action. The chart below shows JNK breaking the summer lows in early October, consolidating into mid November and breaking down again the last two weeks.

The next chart shows the junk bond spreads and CCC bond spreads widening in November and hitting their highest levels since March and January, respectively. Junks bonds are tied to the oil market and recent chaos in West Texas Intermediate ($WTIC) could be weighing here.

Weakness in Spreading

Even though the S&P 500 index, some large-caps and large-cap tech stocks are holding up, there are some serious pockets of weakness in the stock market and this is reflected in the Composite Breadth Model. Note that weakness is slowly spreading throughout the market. Stocks with nose-bleed valuations (highest risk) were hit first and many are down 50+ percent the last six months. Junk bonds peaked in September as money moved out of the riskiest bonds. Third, the Composite Breadth Model turned bearish on December 1st as weakness spread throughout the S&P 1500.

It is clearly not a “normal” environment when the Russell 2000 ETF breaks out to a new high and then falls 10% in the same month. IWM maybe at support and ripe for a bounce, but the bearish signal in the Composite Breadth Model argues for caution going forward. Stocks and stock-related ETFs have a headwind now and the onus is on the bulls to prove the bears wrong.

Thanks for tuning in and have great day!

-Arthur Hill, CMT
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