Beneath the U.S. stock market’s record-setting gains, trouble is stirring.

About 47 percent of stocks in the Nasdaq Composite (CCMP) Index are down at least 20 percent from their peak in the last 12 months while more than 40 percent have fallen that much in the Russell 2000 Index and the Bloomberg IPO Index. That contrasts with the Standard & Poor’s 500 Index (SPX), which has closed at new highs 33 times in 2014 and where less than 6 percent of companies are in bear markets, data compiled by Bloomberg show.

The divergence shows the appetite for risk is narrowing as the Federal Reserve reins in economic stimulus after a five-year rally that added almost $16 trillion to equity values. It’s been three years since investors saw a 10 percent decline in the S&P 500 and they’re starting to avoid companies that will suffer the most when the market stumbles, said Skip Aylesworth, a portfolio manager for Hennessy Funds in Boston.

“The small caps have had big runs and tend to get ahead of themselves,” Aylesworth said in a Sept. 10 phone interview. Hennessy Funds oversees about $5 billion. “It’s kind of like the tortoise and the hare, and they’re the hare. But then they get expensive, and when the market corrects, they get whacked.”

David Fuller's view

Market breadth is deteriorating on Wall Street, as I have mentioned before.  Is this just a temporary pause and normal reaction, or could it be the beginning of something worse?

We are about to find out.  On Thursday, we will see the biggest IPO on Wall Street for a very long time, as the Chinese share Alibaba is floated.  Judging from the preliminary reports it should be a success, at least for Alibaba’s current shareholders.  However, it will absorb over $21.8bn in capital, a large chunk of which is coming from the sales of lesser shares. 

Commentators have pointed out that Alibaba’s float is dwarfed by the over $500bn in US share buybacks during the current bull market to date.  Yes, but that is not the point today.  The share buybacks have played a major role, second only to the Fed’s massive liquidity infusions including QE, in driving Wall Street’s Indices to their recent highs.  Alibaba and other companies in the IPO queue will increase supply.  That will weight on the market, as we are already seeing with shares that have been sold to fund the purchase of Alibaba, unless corporations continue with their share buybacks to the extent of $20bn+ in the near term.  If they do not, then more new money will have to enter the US stock market, but what if current investors decide to err on side of caution and withdraw some capital? 

In other words, we are now more likely to see that elusive 10% plus correction for the S&P 500 that Wall Street has not witnessed in over three years.  Meanwhile, Janet Yellen’s Fed may or may not try to prevent that from occurring at this time.  The US stock market is going to be even more interesting than usual over the next few weeks, as we see whether or not there are still more buyers than sellers.  The price charts will show us, so keep your eye on the Russell 2000, the Nasdaq Composite, the Nasdaq 100, and the DJIA.  Of these, Russell 2000 would give the downside lead.  However, it may be only a minor reaction or consolidation unless the S&P, Nasdaq Indices and DJIA also weaken. 

A 10%+ correction on Wall Street would affect most other stock markets, with many of them experiencing bigger setbacks.