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This ETF is flashing a scary warning for stocks

Be wary of a narrow, selective market

If you think you’ve spotted a robust trend in the markets, there’s probably an exchange-traded fund to capture it. Sometimes this works in reverse; when you own an ETF, it can help you to spot a trend or at least bring one that you suspected was there into sharper focus.

One trend that shareholders of the Guggenheim S&P 500 Equal Weight ETFRSP, +1.42% are becoming aware of may have escaped the notice of owners of more conventional ETFs like SPDR S&P 500 SPY, -0.39% or any casual observer of the markets who has been watching the broad averages glide higher during the last few months.

The market’s advance is getting narrower and potentially more fragile and short lived.

Both ETFs track the S&P 500 SPX, +1.28% , but in different ways. SPY, like the index itself, is capitalization-weighted. Components with the largest market valuations have the largest influence on the index and ETF.

The Guggenheim ETF, in contrast, tries to hold the same amount of each company — from the biggest index constituent, Apple AAPL, -0.43% , to the smallest, Allegheny Technologies ATI, +7.59% The ETF’s managers rebalance the portfolio quarterly by buying and selling holdings to restore the equal weightings.

When the stock market is strong and healthy, just about everything goes up. Shares of businesses big and small, in many sectors, will rise in concert. Not only that, but smaller and cheaper companies often do better than blue chips as risk-seeking behavior increases; that tends to give a performance edge to an equal-weighted portfolio.

That is what has happened for most of the last six years, since the stock market bottomed. From the low in March 2009 through Aug. 6, RSP has risen 245.3%, compared to 177.6% for SPY. In the last three months, however, RSP has lagged noticeably — losing 1.8% while SPY has lost 0.2%.

This could be evidence of waning participation. As risk seeking turns to risk tolerance and then to risk aversion, investors are more inclined to load up on what they see as safer bets, mainly large companies with household names — the Apples of the world more than the Allegheny Technologies.

That flight to safety makes the market and indexes like the S&P 500 top-heavy, leading ETFs like RSP to underperform. Narrowing participation also results in diminishing breadth — fewer issues advancing than declining for any given move in the index than was the case earlier in the rally and relatively fewer issues making new 52-week highs.

A similar reversal occurred in the summer of 2007, just before the financial crisis and the crippling bear market.

Both phenomena have been observed lately, and when they have occurred in the past to a similar degree the result has been unpleasant. As Dana Lyons, a money manager who blogs about the markets, noted in a recent post, an indicator called the McClellan Summation Index — essentially a running total of whatever factor it is measuring — had turned negative both for advances minus declines and new highs minus new lows.

Lyons recorded 59 instances of this since 1970 when the S&P 500 was within 1.5% of a 52-week high. In every one, except for July, for which it’s too early to tell, the index was lower both one- and two years later – with median declines of 8.8% and 21.6%, respectively — as all of the examples clustered around the significant tops of 1972, 2000 and 2007.

The recent weakness in RSP, which seems to be capturing the same declining participation, may not seem alarming after such a substantial run — until you extend the chart back and see that a similar reversal occurred in the summer of 2007, just before the financial crisis and the crippling bear market that accompanied it. SPY dipped and then made a new high in October of that year; RSP had a bigger decline and then a more tepid bounce that left it below its previous high.

That may not happen again, of course. RSP did not exist during previous market turns from bull to bear; 2007 is just one data point. But when taken together with the weakening breadth and what that has meant in the past, it could prove a useful signal that all is not well with the S&P 500, no matter how the components are weighted.

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