The Stock Market's Records Conceal the Crack Forming Below the Surface

The S&P 500 and Nasdaq Composite just below record highs set earlier in the week. However, the number of stocks rising alongside these indices has dwindled, raising concerns for the broader market.

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Technical analyst Tom McClellan, editor of the McClellan Market Report, highlighted on Friday that the New York Stock Exchange's advance-decline (A-D) line has been declining since hitting a short-term peak in early May, even as the S&P 500 has continued to climb. This divergence is troubling, as historically, such patterns have often preceded pullbacks in the index.

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“Normally, the NYSE’s A-D Line mirrors what stock prices are doing. But a bearish divergence like the one we’re seeing now has historically been a significant warning sign,” McClellan noted in his Friday report.

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Even though major indexes like the S&P 500 have seen increased concentration for a while, waning market breadth can still indicate potential problems. McClellan explains that when liquidity, or the available money for investment, begins to dry up, it typically affects smaller stocks first before impacting larger ones. In March, he used signs of declining liquidity to predict an April stock selloff.

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Recently, fewer stocks within the tech-heavy Nasdaq-100 have been rising, which might also signal future issues. McClellan finds the divergence between the Nasdaq-100 and its A-D line even more worrisome than that of the S&P 500 and NYSE. “This divergence is rare and almost never shows a bearish signal,” McClellan remarked.

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He pointed out that this is only the fifth time since 1993 that the Nasdaq-100 has shown a bearish divergence. Previous instances were in 2021, 2000, 2007, and 2015, all of which were followed by market troubles.

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On Wednesday, the S&P 500 achieved its 25th record close of 2024, followed by modest declines on Thursday and Friday, still ending the week higher. Similarly, the Nasdaq Composite hit its 13th record close of 2024 on Wednesday and finished the week up despite small drops on Thursday and Friday.

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McClellan warned that deteriorating market breadth doesn't guarantee an imminent pullback; it might recover in the coming days or weeks. However, it could indicate that the liquidity environment propelling the S&P 500 and Nasdaq Composite to record highs might be weakening.

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Investor anxiety has increased regarding weakening market breadth, especially after three stocks reached a near-unprecedented level of dominance in the S&P 500 earlier this week.

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In summary, while the S&P 500 and Nasdaq Composite have recently achieved record highs, the declining participation of individual stocks in this rally is a cause for concern. Historical patterns suggest that such divergences often lead to market pullbacks. McClellan emphasizes the importance of monitoring the NYSE’s A-D Line, noting that bearish divergences have previously been strong indicators of market trouble. Additionally, the declining breadth within the Nasdaq-100 is particularly alarming, given its rarity and historical significance.

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Although these signals do not guarantee an immediate market downturn, they suggest that the supportive liquidity backdrop may be weakening. This could pose challenges for the continued upward momentum of major indices. Investors are increasingly wary, especially as market breadth narrows and a few stocks dominate the S&P 500. The coming days and weeks will be crucial in determining whether the market can maintain its upward trajectory or if a pullback is on the horizon.

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