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I used to have a single economic model of how the stock market normally behaves under different economic conditions. Now, I have thousands of competing models using mountains of data, and nearly ‘all’ are saying the same thing: Even though U.S. stock market indexes are all near all-time highs, a modest decline is coming to the overall market over the next few months, but a sharp drop of -10% to -20% is likely to hit the high flying technology leaders. The probability of suffering a loss over the next six months is somewhere in the range of 64% to 83%. (The long term average is roughly 20% chance of a half-year loss.) Spoiler alert — the culprit is rising inflation.

Mark Hulbert’s MarketWatch.com column this week focused on a seemingly minor event: Recently the Dow Jones Industrial Average has performed spectacularly well in comparison to the Nasdaq Composite. Both indexes are based on the prices of major U.S. corporations, so, day-by-day they generally perform in largely the same way. But, Hulbert found that the divergence between the Dow and the Nasdaq performance in a recent 7-day period was greater than 99% of all days since 1971 when Nasdaq was created. Hulbert noted: “But 66.9% of the time since 1971, stocks were in a bear market within three months whenever there was a Dow-Nasdaq divergence as large as the current one. “

I track a similar pairing of two slightly different U.S. stock market indexes: S&P 500 versus SPXEW — an equal weighted version of the same stocks as in the S&P 500. Stocks in the S&P 500 are weighted by total market capitalization. As a result, the S&P 500 is dominated by a very small number of mega-sized corporations with lofty P/E ratios. By definition, all stocks count the same in the Equal Weight version. As shown below, the divergence of the two indexes tends to follow a fairly smooth path for years at a stretch, and then rather suddenly shifts in direction. That is what happened over the last couple of weeks — the work horses of the SPXEW did markedly better than the thorobreds controlling the S&P 500. In classic parlance, the Greed that had powered a rapidly rising market has shifted to Caution — investors are moving to less volatile stocks. My models expect that some amount of Fear is next, causing a definite drop in the main averages over the coming few months. Most damage likely will be concentrated in the high flying tech crowd.

The models are pointing to a classic market set-up. The economy is way up. GDP has been running higher than the highly reliable long-term expectations in the Congressional Budget Office Real Potential GDP. The AI infrastructure build-out is huge — nearly 1% of U.S. GDP in new spending. Federal Deficit spending is huge — approximately 5.8% of GDP. Together these are massive unsustainable stimulants to the economy. But, inflation is climbing. The Consumer Price Index is rising at a 4.2% annual rate while the Federal Reserve has a target of 2% annual inflation. But, producer prices have been rising faster — 6.5% for the past year and a full 1% just in May. My models really do not appreciate rising producer prices as they tend to strangle corporate profits. What usually happens is that the Federal Reserve begins to apply brakes to the economy in the form of higher interest rates and tighter money supply. Whether it will is completely unknown.

Though, most of our forecasting models are pessimistic, they are not in panic mode. The two plots below show our long term trend models for the S&P 500 and the SPXEW. Neither of them are highly abnormal. The S&P 500 is 5% above trend and the SPXEW is 11% above trend. Typically, this is as a setup for a pullback, but not necessarily a big one.