ASX Trader: Warning signs flashing as market crash fears grow louder – time to act
After a strong run across US equities, the warning signs are beginning to stack up.
I’m not interested in trying to predict exactly how far the market could fall from here. We simply don’t have enough data yet to know whether the weakness developing across US markets turns into a relatively normal correction or something larger.
But I do think the evidence is telling investors something important.
It’s time to play defence.
I often compare investing to sport. There are times when the conditions are right to attack. You play offence, take opportunities and allow your winners room to run.
Then there are times when the game changes.
You don’t necessarily walk off the field, but you change how you play. You protect what you’ve built, become more selective and wait for the conditions to improve before becoming aggressive again.
I think we are entering one of those periods now.
After some excellent gains, several of the major US indices are beginning to show technical weakness at the same time. Bond yields are pushing higher, market breadth is deteriorating and volatility has been sitting at unusually subdued levels.
For me, the risk-reward equation has changed. From these levels, I currently see more risk to the downside than opportunity to the upside.
The S&P 500 is starting to look vulnerable
Let’s start with the big one, the S&P 500.
The S&P 500 has enjoyed a fantastic run, but technically, the chart is beginning to look tired.
Momentum has weakened, the trend is becoming less convincing and we are starting to see some deterioration in market structure.
Markets rarely go from a beautiful uptrend to a major downtrend overnight. Usually there is a process.
Momentum slows. Buyers become less aggressive. Previous support levels begin to get tested. Rallies become weaker. Eventually, if enough support levels break, the market changes structure and the trend itself changes.
That process is what I am watching now.
The S&P 500 alone isn’t enough for me to become overly bearish. One of the biggest mistakes investors can make is looking at one chart in isolation and creating an entire narrative around it.
I want confirmation.
And unfortunately, when we look underneath the surface of the S&P 500, the picture gets worse.
The average stock is telling us more
One of my favourite charts for understanding the true health of the US market is the RSP, which is the equal-weighted S&P 500.
The normal S&P 500 is weighted towards the largest companies. This means a relatively small group of enormous businesses can have an outsizes impact on what the headline index is doing.
RSP treats the companies much more equally.
Think of it as lifting the bonnet and looking at what the average S&P 500 company is actually doing.
Right now, that chart concerns me.
The equal-weighted index has broken an important technical level and changed market structure.
That tells us weakness is broadening.
A healthy bull market generally wants broad participation. I want to see lots of companies moving higher together, not a headline index being held together by a smaller group of heavyweight stocks.
Recent trading has also shown this deterioration in breadth. In one session this week, 383 members of the S&P 500 were declining, with falling stocks significantly outnumbering advancing stocks.
That doesn’t automatically mean the bull market is finished.
But it is another warning light.
The Dow is joining the weakness
Then we move across to the Dow Jones Industrial Average.
Again, we are seeing deterioration.
The Dow has broken its trend line and is beginning to change market structure.
This is where things become more interesting for me because now we aren’t looking at one isolated index.
We have weakness in the S&P 500. We have deterioration underneath the surface through the equal-weighted S&P 500. And now the Dow Jones Industrial Average is also showing technical weakness.
When several independent charts begin telling me the same story, I listen.
It also leads into one of the oldest concepts in technical analysis, Dow Theory.
The transports were warning us first
One of the fundamental ideas stemming from Dow Theory is confirmation between indices.
The original logic was incredibly simple.
If industrial companies were producing more goods and economic activity was genuinely strong, transportation companies should also be doing well because somebody had to move those goods around.
If industrial companies were booming but transportation companies were falling apart, something wasn’t adding up.
More than a century later, I still love the simplicity of that concept.
The Dow Jones Industrial Average and Dow Jones Transportation Average should broadly confirm one another. Confirmation between the industrial and transportation averages remains one of the central principles associated with Dow Theory.
And here’s the interesting part.
The transports were already leading the weakness.
The Dow Jones Transportation Average has broken down, while the Dow Industrials are now beginning to deteriorate as well. The Transportation Average was recently around 13 per cent below its April peak, even as the Industrial Average had produced much stronger performance.
That is exactly the type of divergence I watch.
One warning sign can be noise.
Several warning signs confirming each other become data.
Then we have bond yields
The next chart investors need to watch isn’t an equity index at all.
It’s the US 10-year Treasury yield.
Yields are breaking higher and technically they look strong.
This matters because the bond market has enormous influence over equity valuations and financial conditions.
Higher yields mean money becomes more expensive. Borrowing becomes more expensive for businesses and consumers, and higher risk-free returns also create greater competition for investor capital.
Most importantly, rising yields complicate the Federal Reserve’s job.
If inflation remains persistent and yields continue pushing higher, the market may have to reconsider the assumption that the next significant move in US interest rates will necessarily be lower.
There is now discussion around whether the Federal Reserve may eventually need to consider another rate increase if inflationary pressures don’t ease. Long-term Treasury yields are already around levels not seen for many years.
Again, I don’t want to predict what the Fed will do.
I want to react to the data.
And right now, the bond market is telling us financial conditions are becoming less comfortable for equities.
September doesn’t help
Then we have seasonality.
Seasonality should never be used by itself to make an investment decision. Just because something happened historically doesn’t mean it must happen again.
But when seasonality lines up with what the charts are already telling us, I pay more attention.
September has historically been the weakest month of the year for US equities.
Depending on the period measured, the exact numbers vary, but the pattern is remarkably persistent. Interestingly, the second half of September has historically been particularly weak.
That doesn’t mean September must fall.
It simply means the seasonal wind isn’t exactly at our back at the same time the technical picture is deteriorating.
Finally, watch the VIX
The final chart I’m watching is the VIX, commonly known as Wall Street’s fear gauge.
The VIX measures the options market’s expectation of S&P 500 volatility over approximately the next 30 days.
In simple terms, when investors are relaxed and markets are steadily moving higher, the VIX generally stays low.
When uncertainty and fear increase, investors start paying more for protection. Expected volatility rises and the VIX can move sharply higher.
That’s why I sometimes think of it as being similar to a fear and greed indicator.
The VIX has been sitting around an important area of technical support after a long period of relatively subdued volatility.
If that support holds and the VIX begins trending higher, it would be another piece of confirmation that the environment for equities is changing.
This is ultimately what concerns me most.
Investors have enjoyed strong gains. Volatility has been low. Complacency has crept into markets.
Meanwhile, underneath the surface, the evidence is changing.
The S&P 500 is showing weakness. The equal-weighted S&P 500 has changed market structure. The Dow Industrials have broken trend. The transports were already deteriorating. Treasury yields are breaking higher. September seasonality isn’t particularly friendly. And the VIX is sitting around an area where volatility could begin expanding again.
Any one of those signals could be ignored.
Together, I think they deserve respect.
We don’t have enough information yet to know how deep the next move will be. That’s what the next few weeks of price action will tell us.
But investing isn’t about knowing exactly what happens next.
It’s about recognising when the probabilities have changed.
Right now, I believe they have.
There will be another time to play offence.
For now, I think it’s time to play defence.
DISCLAIMER: Information and opinions provided in this column are general in nature and have been prepared for educational purposes only. Always seek personal financial advice tailored to your specific needs before making financial and investment decisions.
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Who is ASX Trader?
David Bird is known by his online persona ASX Trader. He is a Certified Financial Technician (CFTe) and former teacher who has built a cult-like following over the years thanks to his ability to use technical analysis to predict stock market movements and trends well before they unfold. Known for his sharp market insights and data-driven approach, he is co-founder of Mastering the Markets, which helps traders and investors develop the skills needed to navigate financial markets with confidence.
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