Inflation may not be the whole story behind the stock market's troubles

US equities stumbled on Wednesday following the release of September's consumer price data, which came in above expectations. Headline prices moved higher and core annual inflation ticked up to 2.6%. Technology shares took the hardest hit, and with futures pointing to further losses today, it is easy to lay the blame squarely on inflation. The straightforward reasoning is that investors fear the Federal Reserve will seize on this as yet another justification to maintain elevated rates "higher for longer".

However, the bond market's response did not align with that narrative. Treasury yields jumped after the data came out but then surrendered those gains and are sliding even lower today. The 10-year yield has dropped to 5.10%, its weakest level in three weeks. Despite this, equities continue to face downward pressure.

So what is going on?

If elevated borrowing costs were the primary worry for stocks, should not the retreat in yields provide some comfort? Furthermore, expectations for the Federal Reserve's October meeting have barely moved. Market participants now see roughly a 29% probability of a rate increase, a modest climb from around 22% yesterday.

While higher inflation is certainly not helping sentiment, it is not entirely convincing that Wednesday's report fully accounts for the selloff.

Let's dig a bit further, shall we? Perhaps the more significant issue is that the broader US stock market has been struggling for a while now, even if the S&P 500's price action has not reflected that.

(hat tip to @KobeissiLetter)

The correlation between the equal-weighted S&P 500 and the traditional cap-weighted index over the past 52 weeks has fallen to about 0.67 earlier this week, marking the lowest level ever recorded. For context, that figure held between 0.95 and 0.99 for nearly 15 years prior to the Covid pandemic. There is clearly a notable divergence emerging in recent years.

But what does that actually indicate?

The declining correlation suggests that the performance of the largest companies is becoming a less reliable gauge of how the average stock in the index is doing. In other words, the S&P 500 is becoming so top-heavy—dominated by mega-cap names—that the headline index can easily mask widespread weakness elsewhere.

And if that is not persuasive enough, consider this: only about 18% of S&P 500 stocks are trading above their 50-day moving average, while just 27% are above their 200-day moving average.

Looked at from the other perspective, that means more than 80% of stocks in the index are below their short-term trend indicator, and nearly three-quarters are below their long-term trend measure. That hardly paints a picture of a healthy market beneath the surface.

I am not suggesting this is proof that a major market correction is imminent. But when participation is already this weak, it takes little to trigger a broader selloff—especially if the heavyweight names, mostly in big tech, that are propping up the index begin to stumble as well.

So, the hotter inflation figures on Wednesday may have given Wall Street another excuse to sell. Yet the fact that stocks continue to weaken even as Treasury yields retreat suggests the market was already fragile well before the inflation data arrived.