This momentum signal suggests caution for stocks

Key points:

• The number of sub-industry groups with a positive 1-year rolling return crossed below 50%
• The decline occurred after a significant number of groups had positive momentum
• The S&P 500 shows negative returns in the 2 & 3-month time frames 

Negative momentum begets more negative momentum

The number of S&P 1500 sub-industry groups with a positive 1-year rolling return fell below 50% on Tuesday. The downward shift in momentum occurred after more than 80% of the groups had positive returns as recently as February 2022.

Let's assess the outlook for stocks after the number of sub-industry groups with a positive 1-year rolling return cross below 50% with a reset condition of 80% to identify instances similar to the current one.

Similar reversals in momentum preceded negative returns for the S&P 500

This study generated a signal 20 other times over the past 65 years. After the others, S&P 500 future returns, win rates, and risk/reward profiles look okay in the short term. Recent signals in the 1-week time frame suggest there's a chance for an oversold bounce. However, the 2 & 3-month windows show negative returns with z-scores approaching significance. In 19 out of 20 instances, the S&P 500 closed below the signal date close in the next few months. I would note that the lower close for the 3/26/80 signal occurred one day later. And while the 8/31/1998 signal marked the low, the S&P 500 got within 2 points of that close on a retest in October.

Sectors and industry group performance after signals

The sector and industry group outlook confirms the cautionary stance for the broad market in the 2 & 3-month time frames, especially for cyclical/value groups like industrials, financials, and consumer discretionary.

Defensive sub-industry group performance after signals

The following table contains 18 sub-industry groups that have performed the best in every bear market since 1957. So, if you're concerned about the outlook for the market, performance amongst these groups looks solid after sub-industry momentum signals.

What the research tells us...

When the number of sub-industry groups with a positive 1-year rolling return crosses below 50% after a reset above 80%, the downward shift in momentum begets more adverse price action for stocks on a medium-term basis. Similar setups to what we're seeing now have preceded negative returns and unfavorable risk/reward profiles in the 2 & 3-month time frames. The signal also suggests we should underweight cyclical/value-oriented groups and overweight defensive stocks in our portfolio.