Liz Looks at: Market Vital Signs

By: Liz Young Thomas · September 28, 2023 · Reading Time: 4 minutes

Paper Cuts

The most recent peak in the S&P 500 occurred on July 31 at a closing level of 4,588. The index has fallen roughly 7% since then. This pullback has been orderly and perhaps to be expected after a near 20% YTD gain. And remember, a correction is defined as a decline of 10% or more from peak to trough, so we haven’t even entered correction territory… yet.

Nevertheless, there are some signs of weakness quietly creeping into markets that feel like a series of paper cuts. We’re not nearing a thousand cuts, but there are enough right now to at least be a nagging pain.

A widely used gauge of market direction is the moving average of a security or index. Typically cited as the 50-day or 200-day moving average (DMA), they can tell us about trends and serve as meaningful levels for market technicians.

The 50 DMA is obviously more sensitive to short-term movements, but can serve as an early indicator of a trend change. The 50 DMA on the S&P 500 recently started trending down for the first time since late 2022. At the very least, it reflects weakening in short-term momentum. At most, it’s the beginning of a breakdown that could prove to be more dramatic. As we know, the truth usually lies somewhere in between.

Since indices are nothing more than a collection of individual stocks, one of the important elements to dig into is how single stocks are holding up. To do this, we can measure how many S&P 500 members are trading above or below their respective moving averages. The chart below uses the 200 DMA to illustrate a longer time period, and is usually a more stringent “test” of strength or weakness.

This is particularly important to watch during a period when the broad index has been so dependent on a small number of stocks. A pullback in the S&P could be due to a more significant pullback in the big names, or a more widespread decline in prices. As we can see from the chart, the number of stocks currently trading above their 200 DMA is a mere 40%, and has been dropping over the last couple months.

This metric is still far from the levels we typically see during major pullbacks (e.g. it fell as low as 11.2% in October 2022, 3.2% during the Covid lows, and 10.8% during the 2018 year-end selloff), but it’s showing clear deterioration in strength across the index.

Not Strong Like Bull

As investors, what we really want to know during a pullback is whether stocks appear oversold, and consequently if we’re more likely to see a bounce or a further fall. One way to look at that is using the Relative Strength Index (RSI), which is a momentum indicator that measures the speed and magnitude of a security’s recent price moves.

A RSI below 30 serves as a rule of thumb that indicates a security is “oversold”. The number of S&P members trading below that threshold has risen from 5% to 22% in a matter of weeks. However, much like the 200 DMA illustration above, this indicator has shown recent weakening, but is still not ringing alarm bells. Major pullbacks tend to see more than 40% of S&P stocks below 30 RSI, and in crisis moments such as the depths of Covid, 75% of S&P stocks were trading below that threshold.

The tricky part about these indicators is that what we’re seeing right now is the result of a gradual move. But if stress hits markets and volatility spikes, they will move quickly, and it’s difficult to protect yourself from the fallout once the tone changes.

Crying Wolf?

It’s nearly impossible to know for sure when a breakdown in these indicators are the beginning of something bigger, or simply a short-term reversal after a period of strong upward momentum. The debate over whether we’re in a new bull market or still in a bear market rages on.

When we take the moves above, and add them to a volatility index (VIX) that’s been slowly grinding higher since mid-September, it’s clear that there are multiple angles of weakness that shouldn’t be glossed over. Still too early to tell whether these will turn out to be flashes in the pan or more ominous warning signs, but when markets are sending wider signals of stress, it’s prudent to consider initiating, or adding to, defensive positions.


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