I just discovered a new leading indicator of US stock market direction. And it is flashing trouble ahead, in my opinion.
The following graph shows the history of the indicator going back to 1998. It forecast the market declines in 2000 and 2008, and is currently forecasting another market correction.
The returns shown in the graph are the average quarterly returns over the year following the indicator date. They’re rolling 4-quarter averages.
A high indicator precedes a market sell-off. A low indicator signals a recovery, and a flat indicator is a predictor of average returns.
I created and maintain the Surz Style Pure indexes that break the stock market into large, middle and small, and within each of these sizes into value, core and growth.
Morningstar style boxes use a similar approach, and were introduced several years after I launched my indexes.
My index definition for large companies is the top 65% of the market. I sort the 6000 companies in the U.S. stock market by capitalization and start adding until I get to 65% of the total capitalization.
I’ve recently noted that the breakpoint for large companies has recently reached its highest point ever – $22 billion. A large company, by my definition, is currently above $22 billion.
There are currently 227 U.S. companies that meet this definition, with total capitalization of $16 trillion, which is 65% of the $25 trillion total market size.
This large company breakpoint is the indicator shown in the graph above. It has successfully predicted the last two market cycles, and is signaling that a major market decline started last year with more to come.
This supports my prediction for a 19% loss in 2016 based on pure fundamentals.
So why does this breakpoint indicator work, and most importantly will it work this time? Here are some possible explanations:
- Mega cap market domination is cyclical, and the (capitalization-weighted) market goes where the mega caps go.
- It’s just another measure of overpricing, big companies becoming too expensive.
- Investors flee to the safety of big companies when they’re worried, and worry ultimately turns into panic.
- It’s not a leading indicator at all. The apparent correlations are spurious.