The Stock Market Is Sending an Unusual Warning Signal

The Stock Market Is Sending an Unusual Warning Signal

Brendan McDermid

The Dow Jones Industrial Average has gracelessly fallen back below the 20,000 benchmark, resulting in what market chartists call an "island gap" formation that has them worried the losses could accelerate to the downside.

Market sentiment is shifting as investors turn their focus from potential positives such as tax reform to negatives (from the perspective of big business) such as a clampdown on immigration and the prospect of chaotic fighting in Congress over everything from President Donald Trump’s cabinet picks to the legality of his executive actions.

Adding to the concern is currency volatility and fears of a trade war — if not outright war.

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Trump complained of foreign currency devaluations (weakening the "strong dollar" post-election trade) and directly named China and Japan as "planning money markets." He reportedly threatened to send troops into Mexico to get the "bad hombres" if Mexico City doesn't. And his national security advisor has formally put Iran "on notice" after a ballistic missile test.

Not even a batch of strong earnings results and post-reporting surges by popular mega-cap tech stocks including Apple (AAPL) and Facebook (FB) this week has been able to reinvigorate broader buying interest.

Apple blasted more than 6 percent higher on Wednesday to a record high after reporting a return to growth for its iPhone business following three straight quarters of declines. Facebook surged in extended trading after reporting better-than-expected earnings and a 53 percent jump in revenues from last year thanks to some very impressive user metrics. Yet both stocks were trading lower by mid-day Thursday.

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Losses have hit other popular tech names, such as Microsoft (MSFT). Market breadth, or the percentage of stocks moving to the upside, continues to narrow precipitously. While stocks overall have flatlined since the middle of December, the percentage of NYSE stocks above their 50-day moving average has fallen from more than 83 percent to just 65 percent now.

Jason Goepfert at SentimenTrader warns that the island gap we've just witnessed — that is, a breakaway gap to a new high followed relatively quickly by a gap back down leaving unfilled space on stock charts — is widely viewed as a negative formation since it shows an "emotion shift between buyers and sellers."

In other words, the euphoria from last week's long awaited close above the 20,000 level quickly gave way to an insatiable urge to book profits and sell. That's more than a little disappointing, given the way Wall Street and the financial media hyped Dow 20,000 for months.

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Looking back through market history since 1982, when the futures market was started, points to a negative performance bias: Six months later, stocks were on average 0.6 percent higher (vs. a 5.0 percent gain for any random six-month period) with a downside risk of 5.6 percent. Most notably, one of the prior occurrences was on October 8, 2007 which marked the death knell of the last bull market.

Amid all this risk, Wall Street is simply unprepared for a downside scenario: At the end of December, according to Goepfert, mutual fund managers were maintaining their smallest cash allocation on record at just 3.0 percent of total assets.

Translation: They are all in and unprepared for an overdue market correction.

Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters. A two-week and four-week free trial offer has been extended to readers of The Fiscal Times.