Analyst warns of ‘Jenga top’ for ‘top-heavy’ stock market

The U.S. stock market isn’t far from records, but recent trading activity could have set the S&P 500 up for a steep decline if it falls below a key point.

According to John Kosar, chief market strategist at Asbury Research, the S&P 500 sits just 1% above a level that, if breached, could trigger a broad selloff.

Kosar’s analysis is based on recent trends in flows into exchange-traded funds. He noted massive inflows into funds tracking the S&P 500. Specifically, $11.8 billion has gone into the SPDR S&P 500 ETF SPY, +0.20% over the past week, according to FactSet data. That influx expanded the ETF’s assets by about 5%; currently, there are nearly $283 billion in assets held in the fund, the first and largest ETF on the market.

Among similar products, $2.5 billion has gone into the Vanguard S&P 500 ETF VOO, -0.33% over the past week while an additional $823 million has flowed into the iShares Core S&P 500 ETF IVV, -0.30% over the same period, according to FactSet data. More broadly, $17.7 billion has flowed into the category of large-capitalization U.S. stocks over the past week, by far the most of any ETF segment. (To compare, roughly $3.5 billion flowed into tech stocks, the category with the second-highest inflows.)

“This represents a new surge of bullish conviction that is immediately positive for the broad market. However, the danger of that much asset expansion, that fast, is that it makes the market top-heavy—like a Jenga game with a lot of newly-added weight at the top,” Kosar wrote.

The SPY, a reference to its ticker symbol, tracks the performance of the S&P 500 SPX, -0.35% by holding the same stocks as the benchmark index, and in the same proportion. Many analysts have said there is a risk in how concentrated the market is, in that the market’s largest stocks have a huge amount of influence over the broad index. The top 10% of S&P 500 components, for example, account for about 21.5% of the index’s weight, while just three companies—Apple Inc. AAPL, -0.28% Microsoft Corp. MSFT, +0.33% and Amazon.com Inc. AMZN, +0.43% —make up nearly 11% by themselves. Apple alone is more than 4% of the entire index’s market value, and that threshold has in the past proved short lived, with dominant companies falling.

According to Kosar’s analysis, which referred specifically to the SPY, a decline below 2,020 “puts more than half of those newly-added assets into the red, and a decline below 2,886 puts all this new money into the red—which could trigger a broad market correction.”

As of Monday afternoon, the S&P 500 is at 2,914.75, or roughly 1% above 2,886.

It should be noted that many market watchers don’t see fund flows as a leading indicator for market moves, especially for the SPY, which is consistently one of the most highly traded securities of any type on Wall Street on any given trading session. Because of the fund’s high levels of liquidity, it is often used as a way for investors to hedge their portfolios or make short-term plays, and if an investor were to make a large short bet on the index—that is, bet on its decline—that would show up as positive flows. As a result, the fund’s flows tend to be incredibly volatile, and it has seen sharp outflows even during bull markets.

Thus far this year, the S&P has gained 9.1%, and it hit record levels last week.

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