One of the early warning signs that a bull market in stocks is nearing its end is increasing selectivity. As more investors begin to believe a peak may be near based on statistical analysis or valuation, they may get positioned more defensively. Eventually we observe some stocks participating in a rising trend as others trend down early. Over the past several weeks we have observed a material divergence between large company stocks like those in the Dow Jones Industrial Average (DIA) vs. small company stocks like those in the Russell 2000 Index (IWM). As you can see below, the Russell 2000 index has declined nearly 9% while the Dow Jones Industrial has gained about 2%. Since the Dow Jones Industrial is more popularly quoted in the media, most investors probably believed “the market was still rising”. But unless you only have positions in the largest company stocks, you’re noticing that isn’t the case in terms of the broad market. Small company stocks tend to lead on the downside, so we shouldn’t be surprised if we see the larger companies follow them down at some point. You can probably see how this basic observation leads to further study of market breadth: looking at what percent of stocks are rising vs. falling.
Is this the “tail” of two markets?
Of course, the direction of the overall market is interesting to monitor, but it only matters what positions we have at risk.
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