3 Reasons This S&P 500 Rally Was Never Going to Get Traction

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Whoops! Correct me if I'm wrong, but wasn't last week's move to record-high territory for the S&P 500 Index supposed to be a sign that higher highs were in the cards? Well, the day after the allegedly catalytic even materialized, the buying effort was stopped cold. Wednesday's modest but measurable pullback from the stock market casts a shadow of doubt on the bullish thrust.

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Thing is, if we're all being brutally honest with ourselves - and cared to look at all the relevant data - we should have known this rally effort from the S&P 500 was likely to peter out before it got going in earnest.

Three red flags stand out more than the rest.

#1: Lack of Participation

This has been a nagging problem since January. While a small crowd of buyers has been compelled enough to buy into stocks following the post-election run-up, most investors have been content to remain on the sidelines. The sheer lack of buying volume necessary to sustain a rally once again was a problem last week.

The chart of the S&P 500 along with the NYSE's up and down volume below is what it is. The swell of buyers two Fridays ago is clear.

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What's also clear, however, is that the number of buyers slumped every single day after that - just as it has with every other failed rally attempt over the course of the past few weeks.

To be fair, it's not like sellers are pouring out of the woodwork, either. Doesn't matter. The malaise itself is enough to keep a lid on stocks.

We just need more buyers for the stock market to move meaningfully higher.

#2: Small Caps Were Never on Board

It's relatively easy to buy large-cap stocks - like the ones found in the S&P 500 index - in any environment. These are large, blue-chip names that aren't apt to suffer too much no matter the headwind they face. As such, any willingness to buy large caps isn't necessarily a barometer of investor bullishness.

Not so with small-cap stocks. These names are big winners when times are good, and big losers when times are tough.

To that end, the Russell 2000 small-cap index of stocks hasn't just lagged the S&P 500's performance since the beginning May. It's clearly being regarded as a liability, with the most recent bullish thrust not even able to break above the resistance of its 20-day moving average line.

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Until investors are optimistic enough to take chances on small caps, they're not going to be optimistic enough to support a sustained rally for the broad market.

The S&P 500 Index Is Overvalued

Finally, while this is the problem that people want to acknowledge the least, the S&P 500 is priced at 21.7 times its trailing earnings.

Stocks are simply overvalued here.

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The counterargument to that idea is, when interest rates are super-low the way they are now, valuations are supposed to be above normal levels. The argument holds water, too … to a certain degree. There aren't very many interest-rate scenarios that legitimately justify a P/E above 20, though, and the current scenario isn't one of the exceptions.

The other counterargument to the notion that stocks can't fundamentally justify their current valuation: You buy stocks for their future earnings rather than their historical earnings. And again, that's a valid premise. It still doesn't quite fly in our current situation. The forward-looking P/E of 18 is still above the long-term norm. And historically speaking, those optimistic earnings projections are usually pared back.

But P/Es are irrelevant right now? That may be the rhetoric, but make no mistake - a bunch of the market's participants are thinking about it, even if they're not saying it.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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