By CHRIS KONSTANTINOS CFA®
Director of Investments | Chief Investment Strategist
- We believe there is little evidence that narrow breadth kills a bull market.
- Market breadth has been broadening in June, in our view.
- Valuations are above average, but we do not believe they are near bubble levels.
This year, the US stock market has climbed the proverbial ‘wall of worry’, confounding the bears fixated on high inflation, the March banking crisis, and the debt ceiling. As these concerns have receded, the current fear du jour is now the ‘narrow breadth’ of 2023’s S&P 500 rally, with just a few high-flying mega-capitalization tech companies responsible for most of the index’s gains.
The S&P 500 is up over 13% year-to-date (YTD) through June 14. An ‘equal-weighted’ version of the S&P 500 – the same stocks, but with each of the 500 weighted equally – is up less than 4% over the same time period. The weightings of the top five largest stocks in the ‘cap-weighted’ S&P 500 – Apple, Microsoft, Amazon, Alphabet and Nvidia – make up over 24% of the entire index as of June 13…a five-decade high, according to Ned Davis Research (NDR) (see chart below).
Is this narrow breadth a reason to be bearish on the S&P 500? In defiance of some market perceptions, we don’t think so. Below we provide some historical reasoning for challenging these perceptions.
Perception #1: “Narrow Leadership is Bad for Future Market Returns”
Reality: We were unable to find historical proof that a ‘narrow market’ is consistently a bad omen for stocks.
We agree that narrow breadth in bull markets tend not to persist over time. However, narrow markets don’t only resolve themselves to the downside, with the high-fliers collapsing as in 1973’s ‘Nifty 50’ bear market, or the bursting of the late 1990’s ‘Tech bubble’ in 2000. At least as often the reverse happens, whereby the rest of the market strengthens and catches up to the early leaders, broadening out breadth and adding another leg to the stock rally. Examples of this include 1980, when the US was coming out of recession, and more recently in 2020, as it became clear the economy was in the process of recovering from the pandemic. These are both periods where the S&P 500 went meaningfully higher over the next year.
As of the end of May, about 20% of the constituents of the S&P 500 were outperforming the index itself on a rolling basis over the prior three months. In the last 50 years, there are only nine other time periods where this percentage has been below 30%. In six of these nine instances, the S&P 500 was actually higher 3 and 6 months later, according to NDR Research.
In studying thousands of historical outcomes going back to 1927 using a broad all-cap US stock index, our opinion is that neither the probability nor the magnitude of positive 3-month forward stock returns were significantly impaired during periods when the number of stocks declining outpaced those advancing (another measure of breadth). This challenges the view that narrow breadth is consistently bad for stocks.
Perception #2: “Current Market Breadth is Poor”
Reality: Across a broad set of indices, advancers are now starting to outnumber decliners and the majority of stocks are now trading above their moving averages, suggesting to us market leadership is broadening.
RiverFront’s investment team monitors a variety of market breadth indicators across different indices, some of which serve as inputs into our historical modelling that helps inform our tactical asset allocation decisions. One of them is the number of index stocks making new 52-week highs versus new lows (New Highs vs New Lows); another input tracks the percentage of stocks in an index that are trading above their longer-term moving averages. A mosaic view into these metrics suggests to us that breadth is actually improving in June, not worsening.
For instance, New York Stock Exchange (NYSE) stocks making new 52-week highs are now outpacing ones making 52-week lows for much of the last few months, suggesting high and rising breadth. In addition, 61.8% of S&P 500 companies, 70.5% of NDR small-cap, and 72.3% of Nasdaq 100 stocks are trading above their 50-day moving averages as of June 14. This suggests to us that under the surface, breadth is actually broadening in June, dispelling the perception that the market rally is only being driven by a small handful of stocks.
Perception #3: “With the Tech Stock Mania, the S&P 500 is now in a Market Bubble”
Reality: S&P 500 valuations are trading higher than historical averages, but nowhere near ‘Tech Bubble’ levels.
Despite the recent tech-led rally, the S&P 500 does not appear dramatically overvalued to us, trading at roughly 18x 12-month forward earnings estimates. While 18x is at the upper end of valuations during non-recessionary periods and a bit higher than the long-term average of roughly 16.5x, it is not anywhere near the 24x number seen at the height of the ‘Tech Bubble’ period from 1998-2000 (chart right, shaded region), before tech stocks spectacularly flamed out. In fact, today’s valuation levels were visited multiple times prior to COVID.
Conclusion: Breadth Itself not a Reason to be Bearish; Markets Sending us Increasingly Positive Message
With the S&P 500 having definitively broken out above its ‘decision box’ range of 3800-4200 laid out in prior weeklies, we are modestly bullish and thus slightly overweight equities in our portfolios. While we prefer select mega-cap technology stocks as a theme, we also recognize the growing opportunity in equities outside that universe as market breadth broadens. Some other preferred portfolio themes include dividend sustainability, reflation plays in energy and materials, and moving down in size, both broadly and specifically in industrials in our longer-horizon portfolios.
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Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.