GLOBAL STOCKS RESUME SELLING -- U.S. STOCK RALLY HAS BEEN TOO NARROW AND VULNERABLE TO A DOWNSIDE CORRECTION -- GAP BETWEEN SMALL AND LARGE CAPS IS A WARNING SIGN -- SO IS THE DROP TO 40% IN THE NYSE BULLISH PERCENT INDEX

SMALL CAPS ARE LEADING LARGE CAPS LOWER... Global stocks have started the year on a bad note. Most of that is being blamed on China. A plunge in Chinese stocks and a drop in the Chinese yuan to a five-year low are certainly causing a lot of worries in global markets. But there's more than that going on. That's especially true in the U.S. It's been pointed out, for example, that the fourth quarter rally in the U.S. was primarily a large cap rally, and that smaller stocks have been lagging too far behind. In addition, it's been mentioned that several measures of "market breadth" have not been keeping pace with large cap stock indexes. All of that has left the U.S. market vulnerable to a setback. I suspect that events in China were the catalyst causing the selling to begin. Let's start with the gap between large and small cap stocks. In a healthy uptrend, large and small caps usually rise together. In fact, small stocks usually lead large caps higher. At market tops, small caps are often the first to weaken. Chart 1 shows the wide gap between the S&P 500 Large Cap Index (black bars) and the Russell 2000 Small Cap Index (red line) over the last year. The gap between the two was especially evident during November when the S&P 500 came within a percentage point of its old high, while the RUT remained more than seven percent below its summer high. Since then, the RUT has fallen to the lowest level since early October. The red line on top of Chart 1 shows a ratio of small caps versus large caps falling since mid year to a multi-year low. That's not a healthy situation.

(click to view a live version of this chart)
Chart 1

NYSE BULLISH PERCENT INDEX IS TOO LOW... The NYSE Bullish Percent Index ($BPNYA) measures the percent of NYSE stocks in point & figure uptrends. It's one of the measures of "market breadth" that helps determine if the broader market is keeping pace with large cap stock indexes. Unfortunately, it's showing a huge "negative divergence" from the S&P 500. The red line in Chart 2 shows the BPNYA peaking at 67% during April which meant that roughly two-thirds of big board stocks were in p&f uptrends. During November, the red line reached only 55% as the SPX approached its old high. It has since dropped to 40%. That means that nearly two-thirds of NYSE stocks are in point & figure downtrends. That's not a healthy sign for the market. At the start of 2012, when the last stock correction ended, the red line was close to 70%. The current low reading shows that the large cap stock indexes are masking much broader weakness in the rest of the market.

(click to view a live version of this chart)
Chart 2

NEARLY THREE QUARTERS OF STOCKS ARE BELOW 200-DAY LINES... The stock market is a market of stocks. A bull market can only exist when most stocks are in uptrends. That's not the case right now. The red line in Chart 3 measures the percent of NYSE stocks above their 200-day moving average. Right now, the red line is trading at 27%. That means that nearly three-quarters of NYSE stocks are trading below their 200-day line (and in downtrends). The red line peaked near 80% in the middle of 2014. It reached 64% last spring as the S&P 500 hit a record high. During the November rally, the red line only reached 38%. It's not a good sign when the red line is weakening. And it's been doing that over the last 18 months. The flat green line marks the 50% level, which helps distinguish uptrends from downtrends. During the first half of 2009 (when the latest bull market started), the red line rose above 50% (first green circle). It did the same at the start of 2012 (second circle). Right now, it's below 30% and dropping. Obviously, that's not the sign of a healthy stock market. One way or the other, the wide gap between the red line and the S&P 500 needs to narrow. That can happen by the red line rising, or the S&P 500 falling.

(click to view a live version of this chart)
Chart 3

FOREIGN SHARES ARE STARTING TO WEIGH ON THE U.S.... Another warning sign for U.S stocks is the growing divergence between them and foreign shares. Generally speaking, a positive correlation usually exists among global stocks. A healthy bull market usually requires that most global stocks are rising together. That's not the case right now. The red weekly bars in Chart 4 plot the Vanguard FTSE All-World ex US ETF (VEU). [The VEU includes foreign developed stock markets and has a 25% weight in emerging markets]. Chart 4 compares the VEU (red bars) to the S&P 500 (black bars) since 2012. Both rose together from 2012 until last spring, which was good. They've been diverging since then which is potentially bad. First, the VEU formed a "double top" between mid-2014 and mid-2015 (while the S&P 500 hit a new high). That was the first warning sign. The negative divergence between U.S. and foreign shares has gotten much bigger since then. Since last May, the VEU has lost -16% versus a -4% drop in the S&P 500. [Although the biggest VEU losses were in emerging markets, foreign developed markets also underperformed the U.S.] In addition, the VEU has undercut its 2014 low and is nearing a test of its 2015 low. That's a very important test for it and U.S. stocks. It's hard to see how the U.S. market could withstand a breakdown in foreign markets.

(click to view a live version of this chart)
Chart 4

WILSHIRE 5000 INDEX MAY RETEST SUMMER LOW... The Wilshire 5000 Composite Index (WLSH) includes virtually the entire U.S. stock market and is much more broadly based than the Dow 30 or the S&P 500. [One caveat: The WLSH is cap-weighted, and the top 500 stocks account for 70% of its value]. Even so, it may offer a better perspective on the U.S. stock market than the more narrowly based large cap indexes. The daily bars in Chart 5 show the WLSH testing its December low and in danger of falling to a three month low. That would raise the possibility for a retest of last year's second half lows. Chart 6 gives a broader perspective of the potential topping pattern that's been forming in the Wilshire since the second half of 2014. A potential "neckline" is drawn under its October 2014 and 2015 lows. I don't have to tell you that's a very important line of support.

(click to view a live version of this chart)
Chart 5

(click to view a live version of this chart)
Chart 6

NOT VERY OPTIMISTIC FOR THE NEAR YEAR... You've probably figured out by now that I'm not very optimistic for 2016. The bull market that started in spring 2009 will be seven years old this March. In addition, the last two bear markets were eight years apart (2000 and 2008). 2016 is eight years from 2008. That worries me. The fourth quarter test of old highs by the U.S. market was much too narrow and has failed. Weakness in foreign markets is another warning sign. That increases the odds for a market correction. I think there's a good chance that stocks will retest last year's second half lows. Then we'll see what happens from there. Let's hope they hold.