This S&P 500 sector gauge points to ‘excessive’ confidence and imminent pullback
Sectors in the U.S. stock market just traded in a way that suggests investors are excessively confident and a pullback may be near — although that doesn’t necessarily spell the end of the S&P 500’s bull run, according to DataTrek Research.
Correlations for five major S&P 500 sectors hit an unusually low level that since 2023 has been followed by a drop for the U.S. equities benchmark. “Every other time they have done so since 2023,” the S&P 500 has declined by 5% to 18% in the following weeks, DataTrek co-founder Nicholas Colas said in a note emailed Thursday.
He tracked the trailing 30-day price correlations for the technology, industrial, consumer discretionary, financial and healthcare sectors versus the S&P 500 in the chart below, finding they recently fell more than 2 standard deviations below the long-term average.
Since the current bull market began around late 2022 and early 2023, “abnormally low sector correlation readings” of below 0.61 line up with near-term tops for the S&P 500, Colas found.
The S&P 500 SPX ended Thursday at a fresh all-time high that marked its 30th record close of the year, with the bull market continuing amid some concerns over stretched valuations.
“S&P sector correlations currently reflect excessive investor confidence, but history shows we still need a catalyst to come along and reset them back to more rational levels,” wrote Colas. Until one appears, he said that U.S. large-cap stocks may keep “slowly drifting their way higher.”
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The U.S. stock market so far appears to be taking the U.S. government shutdown that began on Wednesday in stride. The shutdown has left investors navigating markets without fresh economic data that the government had been scheduled to report, including data on initial jobless claims that normally would have been released Thursday morning.
Meanwhile, S&P 500 sector correlations, as measured by Colas, fell last week to the unusually low levels of 0.596 on Sept. 24 and 0.607 on Sept. 25. He found that’s just below the 2-standard-deviation level of 0.61, which has “served as a reliable sign of an imminent pullback since the start of 2023.”
Still, DataTrek remains bullish on U.S. large-cap equities, according to his note.
“This is NOT a ‘sell everything today’ signal,” Colas wrote. “While we believe our correlation work does a good job of signaling near term highs, we know reliably calling tops is ferociously difficult.”
DataTrek will be watching the Cboe Volatility Index to potentially signal a “sensible entry point” to buy the dip should one emerge following the low sector correlation levels that the firm identified, according to Colas.
The volatility index, which is known by the ticker symbol VIX VIX, has been trading below its long-term average of 19.5, which it tends to do during bull markets, he noted. It rose to around 16.6 on Thursday, according to FactSet data.
To Colas’s thinking, “a VIX above 19.5 should signal temporary market unease,” opening up a tradeable or investable event.
“Since the start of 2024, the VIX has crossed from below to above the 19.5 average on 11 occasions,” he wrote. “The average 1-month gain after such a move in the VIX has been +2.2 percent, with a win rate of 82 [percent] and a maximum drawdown of -2.9 percent.”
The U.S. stock market closed higher Thursday, with the S&P 500 rising 0.1%, the Dow Jones Industrial Average DJIA gaining 0.2% and the technology-heavy Nasdaq Composite COMP advancing 0.4%. All three indexes finished the trading session at fresh record peaks, according to Dow Jones Market Data.