Latest Economic Review: Sunpointe Illuminations

Market Breadth – what does it tell us now?

As many investors have noticed, the S&P 500 equity index has been powered this year by a small group of mega-cap technology stocks. These stocks are shown below in the chart as of June 1, 2023. Yardeni Research has termed this group the Mega-Cap 8.

 

In Wall Street parlance, “market breadth” can be measured by multiple indicators, but the general idea is that if more stocks are declining than advancing, it is indicative of an unsustainable advance. “Narrow breadth” occurs when a small group of stocks leads the way while others do not keep up.  Investors typically look for a broad-based rally across most stocks and sectors in a particular index as evidence that a stock rally “has legs,” and is therefore sustainable given that the equity sectors and industries are integrated. For example, strength in manufacturing input sectors (energy, materials) leads to demand in finished goods sectors (consumer discretionary and consumer staples). Narrow breadth can be a good or bad signal – potentially a market top or a market bottom.  The difference has to do with earnings growth.  In the past, when there was a situation of extremely narrow breadth coupled with a market bottom, earnings growth was close to a trough. In the cases where narrow breadth turned out to be a warning sign, earnings growth was near the top.

Source: State Street

In the current “decent” economic environment, there appears to be comfort (and maybe some FOMO) associated with the big tech names given the AI story coupled with strong balance sheets.  The broader market isn’t attracting buyers to less profitable, riskier stocks – investors are less willing to spread their capital among the rest of the index.  If we were to see a weaker economic environment, investors may become even more uncomfortable with concentrated tech exposure and may decide to cut overall equity risk and wait for better economic times in 5% in risk-free Treasury bills (why not?).

But, history tells us that eventually there will likely be a reversion to a more typical relationship between market breadth and price performance at some point. However, the timing is uncertain.  Excitement over the advances in artificial intelligence has gripped investors and some see these stocks plus other tech names nearing possible bubble territory.  A rotation into undervalued sectors at some point clearly makes sense.  If we continue to see this diversion, we may indeed recommend an equal-weighted index.