NEW YORK (TheStreet) -- A big red light is flashing that the stock market is headed into a broad decline.
The Guardian Indicator, a market strength gauge, turned negative Thursday, indicating a long-term bearish trend. This indicator from Reality Shares Advisors (disclosure, my company) last signaled a negative market environment on Jan. 10, 2008 and remained in negative territory until July 14, 2009. During that period the S&P 500 Total Return index (^SPXTR) fell 33.78%. Before that, Guardian last turned negative on Sept. 15, 1999 and remained bearish for all but three trading days until May 22, 2003, which would have avoided a decline of 20.87% in the S&P 500 Total Return Index.
Just one month ago, we warned that continuing volatility and price pressure in the health care, consumer staples, or telecom services sectors could be the tipping point for a bearish Guardian Indicator. It was ultimately weakness in consumer staples sector that carried it over the edge by the close of trading Wednesday, bringing the sector into negative territory along with energy and utilities, and thus triggering the alarm for the entire market.
The Guardian methodology applies a combination of momentum and downward-volatility gauges to each of the 10 major market sectors, with a negative reading in both factors signaling a decline in that sector. To determine the strength of the overall market, we aggregate the Guardian scores from each of the 10 market sectors, and when eight or more are positive, the overall market is expected to rise. When three or more sectors turn negative the Guardian Indicator is negative, and it signals a broad market decline. Taken as a whole, the methodology is designed to be more selective in its entry and exit points than simple moving averages, and to mitigate the influence of any single sector.
While the stock market correction in August played a role in accelerating the Guardian signal, it is worth noting that the long-term trends leading up to the current red flag have been unfolding since last year. The first sector to receive a negative signal was utilities, which suffered from elevated volatility and falling share prices in early February as expectations jumped for rising interest rates this year. Utility stocks, often viewed as a substitute for fixed-income products due to their high dividend yields, suffered as investors rotated into other investments looking for more attractive rates. As a result, downward volatility levels exceeded long-term averages for the sector on March 9, 2015, and when price momentum likewise fell below the threshold level on April 27, it triggered a negative signal for the sector.
Energy sector stock prices have been falling since last summer when crude oil began its downward spiral from more than $100 a barrel to its current levels in the mid-$40's, so the sector entered 2015 with its price momentum well into negative levels. However, since a warning isn't triggered until both its price and volatility gauges pass their thresholds, it wasn't until the sector's negative volatility levels exceeded long-term averages on May 15, 2015 that the energy sector became negative.
The decline in consumer staples has occurred quickly relative to the other sectors, as the sector fell from the fourth-highest Guardian score at the end of 2014 and the third-highest score at the end of June 2015 into bear market territory at the close of trading on Sept. 16, 2015. Unlike the energy and utility sectors, the price momentum and volatility components moved into negative territory almost in tandem, with negative volatility crossing the threshold less than a week earlier, on Sept. 10. But the net result is the same, and with three negative sectors indicating broad market weakness, Guardian is now signaling a market decline.
Looking ahead, the health care and telecom services sectors have fallen even closer to a negative signal over the past month, accelerated by the mid-August market volatility, and the information technology sector has now joined the list of sectors in caution territory. If these or other sectors turn negative, it could indicate a longer or more severe decline in the market.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned. This article represents the opinion of Eric Ervin and may not represent the view of Reality Shares.