It doesn’t have to be the end of the world in order for investors to exercise a bit of caution. While many stocks remain well off their all-time highs, many indices are doing quite well. In fact, they are erasing a bulk of the 2022 bear market losses. However, there are some stock market red flags and stock market risks to watch.
The S&P 500 is down 10.75% from its all-time high — but officially back in a bull market by some measures — and the Dow Jones Industrial Average is down just 8% from its highs. The Nasdaq and Russell 2000 are doing a bit worse, but overall, there’s no denying that they’re up big from the lows.
Identifying a few stock market red flags does not mean turning full-on bearish and going short on everything in sight. It means understanding stock market signals and paying attention to a few warnings. It means protecting capital and considering some defensive measures, like trimming positions and/or potentially raising some cash in the event of a larger correction.
Let’s look at a few stock market risks.
Bad Breadth
Most of this year’s stock market gains have been from just a handful of stocks. In fact, almost 90% of the year-to-date gains can be traced back to just seven stocks. While that data may be a touch outdated, there’s no question that mega-cap tech has been steering the ship.
Meta (NASDAQ:META), Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), Nvidia (NASDAQ:NVDA) and a few others have been storming higher. All the while, many other stocks continue to struggle.
Admittedly, there’s been an inkling of rotation underway, with selling pressure in tech and strength in small caps and a few select sectors. However, it’s too early to know whether that rotation has any meaningful strength.
As Callie Cox wrote, “By one measure — the S&P 500’s cumulative advance-decline line — the balance of rising to falling stocks during May was the worst for a monthly gain in at least the past two decades. ”
Is this an outright sell signal? No. However, bad breadth leaves the market vulnerable to the performance of just a few stocks unless money continues to rotate into other groups — nd that ups the risk a bit.
Rising Rates and a Strong US Dollar
The connection between certain asset classes can be complicated, but these two are relatively straight forward. A strong US dollar puts pressure on profits of multinational corporations, while higher interest rates are a negative for businesses and stocks.
Higher interest rates decreases lending and liquidity, which is an obvious negative. But more than that, higher rates make other assets (like bonds and CDs) more attractive against stocks.
That said, bull markets can coexist with multiple headwinds — Including higher rates and a higher dollar. A week ago, the US dollar and 10-year Treasury yields hit a multi-month high, with the latter up more than 18% from the low.
Equities didn’t seem to mind. However, if that trend continues, it’s likely to take a toll.
Inverted Yield Curve, Weakening Economic Data
The 2-year/10-year Treasury yield curve is closely watched as an indicator for an economic recession. It’s not perfect, but when inverted over longer stretches of time — in other words, brief inversions are not as accurate — it can help in predicting an economic contraction.
So far, that hasn’t been the case.
The 2-year/10-year Treasury yield curve hit its lowest point in early March, but it’s still firmly negative. Interestingly, it’s been negative for almost a year now after inverting in early July. It’s also worth noting that the 3-month/10-year yield curve has been inverted since October.
I wouldn’t say this alone means there will be a recession, but its persistent inversion is noteworthy.
While the labor market remains fairly robust, the recent PMI data from June 1 all missed expectations. Further, these readings were all below 50, which indicates contraction. All the ISM data so far this month has also missed expectations. Lastly, the recent jobs claims data — which “measures the number of individuals who filed for unemployment insurance for the first time during the past week” — Is bumping against multi-year highs.
To some extent, this is what the Federal Reserve wants — slower economic activity to take the heat out of inflation. However, the Fed also pushed through interest rate hikes at record pace, so it’s hard to tell what it’s lagging effect could be.
On the date of publication, Bret Kenwell did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
