Market Breadth Divergence – A Concerning Signal Ahead?

The stock market has been hitting new record highs lately, with the S&P 500 and Nasdaq making fresh all-time peaks. However, a concerning divergence in market breadth data suggests this rally may be on shaky ground.

Market breadth refers to the participation of stocks in a price move – how many are advancing versus declining alongside the overall market direction. Recently, we’ve seen a stark divergence where only a handful of mega-cap tech stocks like Nvidia, Microsoft, Alphabet, Amazon and Meta are driving the major indexes higher while the majority of stocks are flat or down.

For example, on one recent day, just 30% of Nasdaq stocks were advancing while 67% were declining. And for the year, around 60% of the S&P 500’s 20%+ gains have been driven by just 5 stocks – Nvidia, Microsoft, Alphabet, Amazon and Meta.

This lack of broad participation raises a red flag. When only a few names are propping up the indexes, it signals an unhealthy, narrowly-led move that may be unsustainable. Broad participation in an uptrend, with the majority of stocks rising, lends far more confidence.

We’ve seen this type of divergence precede market tops before, like in the Dotcom bubble when a handful of stocks became the whole market before crashing. The problem is investor psychology – people get sucked into chasing the big winners, often with no risk management plan when the inevitable turn arrives.

Indeed, Nvidia insiders have already cashed out over $700 million in shares this year as the stock skyrocketed higher. CEO Jensen Huang alone sold $31 million worth recently. When insiders take profits like this, it’s wise for investors to consider doing the same and locking in some gains.

Of course, this incredible rally driven by AI and big tech juggernauts could persist for some time further, especially heading into the election. But eventually, fundamentals like slowing sales growth or economic weakening will likely hit, potentially triggering a harsh reversal in these narrowly-led indexes.

As investors, it’s prudent to enjoy the gains while adhering to sound risk management principles – using stop losses, taking some profits along the way, and being prepared to let winners become ex-winners when the music stops. Riding a bucking bull is thrilling until you inevitably get thrown off – the key is having a plan to land on your feet.