Assessing the Technical Damage

Adam Turnquist | Chief Technical Strategist

Last Updated:

Key Takeaways

  • Volatility came back with a vengeance this week as selling pressure in the mega cap space dragged down the broader market. Counterbalancing weakness in these heavyweight names poses a challenge for the rest of the market.
  • Overbought conditions can also be blamed for the recent weakness. The S&P 500 reached a 14.9% premium to its 200-day moving average (dma) last week, marking the highest level since 2011. Historical comparisons point to momentum continuing over the next year, but not on a linear path.
  • Technically, the S&P 500 violated a short-term uptrend yesterday as momentum indicators turned bearish. While there is a growing risk the current pullback continues lower, there is plenty of support before the longer-term uptrend is challenged. Furthermore, longer-term breadth metrics and overall market leadership remain bullish.
  • Based on this backdrop, we recommend a neutral equities allocation and tactically buying dips once support is established and momentum improves.

Investors have enjoyed a relatively quiet ride aboard this year’s double-digit rally. Until yesterday’s 2.3% drop, the S&P 500’s worst single-day decline has only been -1.6% this year. (For context, since 1950, the index has generated a daily decline of 1% or more 25 times a year, with 2% drops or more occurring an average of six times a year.)

As the saying goes, what goes up tends to come down, and that adage applies to both price action and sentiment in markets. Enthusiasm surrounding artificial intelligence (AI) witnessed a bit of a reality check yesterday. Google’s parent Alphabet (GOOG/L) reported better-than-expected earnings and revenue but slowing ad revenue from YouTube and a jump in AI-related capital expenditures (capex) weighed on the stock. The company spent $13.2 billion on capex during the second quarter (Q2), ahead of expectations and nearly double the $6.8 billion spent in Q2 of last year. Shares fell 5% as investors appeared to be spooked by the scale of spending on AI, a trend likely to continue according to Alphabet CEO Sundar Pichai, who mentioned on the earnings call, “The risk of underinvesting is dramatically greater than the risk of overinvesting for us here.”

To make matters worse for mega caps yesterday, electric vehicle maker Tesla (TSLA) also reported underwhelming earnings, including declining automotive revenue and falling margins. Selling pressure from these disappointing results spilled over into the rest of the Magnificent Seven (Mag Seven) and the broader market. As highlighted below, the concentration risk of the Mag Seven is hard to counterbalance. For the S&P 500 to break even, declines in the Mag Seven would need to be matched by equivalent moves across the entire financials, healthcare, and industrials sectors — a collective group of 212 stocks.

Mega Cap Weakness is Hard to Offset

This chart depicts the percentage of various sectors in the stock market. The sectors are Financials, Health Care, Industrials, Technology, and Communications.

Source: LPL Research, Bloomberg 07/24/24.
Disclosures: All indexes are unmanaged and cannot be invested into directly. Past performance is no guarantee of future results. Any companies referenced are being presented as a proxy, not as a recommendation.

Technical Setup

The current pullback is a classic example of overbought conditions running into overhead resistance. The rally off the April lows created a steep and unsustainable uptrend that happened to overlap with the 20-dma — a dynamic area of support where buyers have consistently stepped in with demand on the dips. However, as the S&P 500 stretched to historically overbought levels and eventually reached the upper end of its longer-term rising price channel, supply overcame demand and a pullback recently ensued.

Momentum is confirming the change of character in this recent rally. The Relative Strength Index (RSI) — a momentum oscillator used to measure the velocity of price action to determine trend strength —has dipped into bearish territory after taking out support from the May lows. This sequence of events is not unique to this bull market. As highlighted below, retests of the upper end of the channel have closely been followed by breakdowns in RSI. The good news is that there is still a lot of support in play before the S&P 500’s longer-term uptrend is challenged, including 5,375 (price gap), 5,321 (May highs), 5,254 (March highs), and the April lows/200-dma (4,953-4,969). We consider the latter as a worst-case scenario for stocks given longer-term breadth metrics and overall market leadership remain bullish.

S&P 500: Overbought Conditions Meet Overhead Resistance

This chart depicts the SPX Index from August 2022 to July 2024. It is a technical analysis chart, showing several key indicators.

Source: LPL Research, Bloomberg 07/24/24.
Disclosures: All indexes are unmanaged and cannot be invested into directly. Past performance is no guarantee of future results. Any companies referenced are being presented as a proxy, not as a recommendation.

As highlighted above, the price of the S&P 500 reached a 14.9% premium to the 200-dma last week. Like a rubber band, prices generally only stretch so far above long-term averages before an eventual pause or snapback. We applied standard deviation bands to help quantify when this turning point could occur, and last week’s near two-standard deviation premium to the 200-dma certainly qualifies as an outlier move (highest since 2021). To provide added historical context, we found prior periods when the index reached at least a 14.9% premium to its 200-dma for the first time in at least 30 days (the time filter was utilized to avoid overlapping signals). The average forward returns and maximum drawdowns following the other 38 occurrences since 1950 are highlighted in the chart below.

S&P 500 Returns After Reaching a Historically High Premium to the 200-dma

Chart depicting the average return, average maximum drawdown, and percent positive for different time periods.

Source: LPL Research, Bloomberg 07/25/2024
Disclosures: All indexes are unmanaged and can’t be invested in directly. The modern design of the S&P 500 stock index was first launched in 1957. Performance back to 1950 incorporates the performance of the predecessor index, the S&P 90.

We found that strong momentum observed during these periods historically continued over the following year, evidenced by the S&P 500’s average 12-month gain of 11.7% (84.2% of periods also produced positive results). However, the path is not linear as the maximum drawdown over the following 12 months averaged 13.2%.

Summary

Technical damage is beginning to mount for the broader market. Yesterday’s drop took out key support at the 20-dma and violated a short-term uptrend. Momentum confirmed the breakdown as select indicators turned bearish for the first time in several months. While mega caps captured most of the blame for the recent selling pressure, historically overbought conditions were also a key factor behind the pullback. The good news is that there is still a lot of support in play before the S&P 500’s longer-term uptrend is challenged and strong momentum tends to be sustainable on a longer-term basis, although the path is not linear. Based on this backdrop, we recommend a neutral equities allocation and tactically buying dips once support is established and momentum improves.

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Adam Turnquist

Adam Turnquist oversees the management and development of technical research at LPL Financial. His investment career spans over 15 years.