Some ominous storm clouds are forming on the stock market’s horizon.
This sobering news is brought to you courtesy of an obscure indicator based on the relative performance of the S&P 500’s sectors. The sectors that right now are at the bottom of the relative strength rankings are the same as those that have regularly lagged prior to past bull market tops.
You may recall that I introduced you to this indicator in a column last Fall, when it was telling a bullish story. Unfortunately, the indicator is even more bearish today than it was bullish then.
Consider the sectors that, on average, performed the worst over the three months prior to every bull market top since 1970. According to Ned Davis Research, those sectors are financials, utilities and energy. Sure enough, these are the three sectors that have the worst returns over the past three months.
The sectors that on average performed the best prior to past bull market tops are consumer discretionary, healthcare, and information technology. In a ranking of returns over the past three months, these three are in second, seventh and third places, respectively. This isn’t as perfect a match as in the case of the bottom performers, but it’s still pretty close. See accompanying chart.
How close? To measure how similar current sector relative strength is to the pattern prior to past bull market peaks, we can turn to something known as the correlation coefficient. It ranges from a high of 1.0 (which would mean that there is a perfect 1-to-1 correspondence between a ranking of the sectors’ recent returns and the historical pattern) to minus 1.0 (which would mean a perfectly inverse correlation). A coefficient of zero would mean that there is no detectable relationship.
The coefficient currently stands at 0.61, which is worrisome. The coefficient that prevailed when I wrote my column last November stood at minus 0.10.
To be sure, this indicator is not foolproof. None is. It didn’t anticipate the waterfall decline in February and March of this year, for example -- though, in its defense, it’s worth pointing out that forecasting a pandemic is next to impossible.
The indicator does have some notable successes to its credit. In April 2015, for example, I reported to clients that the indicator was telling a bearish story; a bear market began one month later, according to the bull/bear calendar maintained by Ned Davis Research. The indicator today is even more bearish than it was then.
To the extent the indicator works, it does so because certain sectors perform better than others during an economic downturn, and the stock market does a good job of anticipating what’s coming around the corner.
Consumer and healthcare companies tend to hold up well during downturns, for example, which explains why they are ranked so high for relative strength as bull markets take their last breaths.
At the opposite end of the spectrum, utilities and energy companies suffer during downturns since economic weakness reduces remands for electricity, fuel and related products; this is why they are so weak as bull markets come to an end.
It’s always possible that this indicator, after walking up to the edge of the cliff, decides to turn back, giving the bull market a lease on life. That would happen if the currently weakest sectors -- financials, utilities and energy -- suddenly start leading the market. In the meantime, however, the indicator is urging us, at a minimum, to be cautious and not get seduced into the bull market’s euphoria.