Does a Narrow Market Narrow the Markets’ Possibilities?

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We certainly hope you have enjoyed the terrific S&P 500 & Nasdaq 100 market action over the last eight months. Although the price of these broad indexes has enjoyed nice gains, the concern that continues to be espoused is that of not enough companies joining the party, or as the market commentators call it, breadth.

Narrow market breadth is the latest recycled bear case garnering attention. Market breadth?refers to how many stocks are participating in a move in an index.

Let’s debunk this one. Again. Narrow stock market leadership is a feature, not a bug, and it doesn’t predict imminent losses.

What Investors Should Know

It seems to be that time of year again when everyone claims the market is only moving higher due to a few names, suggesting the gains can’t possibly hold.

Market participants prefer to analyze the degree of participation in an advance or a decline to determine whether an uptrend or downtrend is broad-based and likely to continue. Strong participation is considered a sign of a healthy market, suggesting the existing trend should persist.

Divergences in breadth measures and price trends are thought to be leading indicators for the market’s direction. For instance, a rising price index matched with falling breadth is often considered a negative divergence, acting as a warning sign that market momentum is likely to begin fading.

Just like this time last year, market leadership has been thin for the past month or so, with a handful of names, namely NVIDIA, driving the majority of index returns, creating a bearish divergence. From a technician’s perspective, this is considered unhealthy and gives reason for pause regarding risk appetite and the path for equities moving forward. It sounds great and gets clicks each time participation narrows, but the data suggests otherwise.

What We See

This should all sound familiar. If we look back at past periods of market advances, and if you refer to the statistical chart from last week’s report, it is shown that this tends to be a common occurrence. So, we would tend to conclude, “If it ain’t broke, don’t fix it.” But for the uninitiated, let’s set the stage for what breadth is, why narrow breadth is a classic bear argument, and why it doesn’t indicate what the masses think it does.

There are plenty of ways to measure breadth: new highs vs. new lows, percentage of issuers above their 50- or 200-day moving averages, advancing issues vs. declining issues, to name a few. Pick your indicator. However, some will find evidence that one metric is useful while another will prove to be faulty. That same metric may work at some point and then at a later stage, it will give a false signal.

Many of the charts floating around lack the data analysis to back up the validity of their claim. Plenty of investors are saying weak breadth is bad, so it must be true. But much of the empirical evidence that we have sifted through shows that breadth tends to catch up to price, rather than prices catching down to breadth. In other words, breadth doesn’t lead price; price leads breadth.

More importantly, narrow breadth tends to be part of the personality of a market movement, not a bug. A vast majority of the returns in markets are driven by a small subset of the constituents. That’s right, a handful of names driving indices higher is the norm.

Poor breadth isn’t intrinsically a sign of unsustainable gains for the indices, but rather it seems to be more a reflection of a stronger opinion of the subset and investor appetite for risk. Last year, breadth was narrow and getting thinner, despite the upward trajectory for indices bouncing off the October 2022 lows. But that wasn’t all that surprising. Would you be investing in the broad market that includes highly speculative names if you believed the Fed was driving the economy off the cliff with its almost relentless interest rate hikes? Or would you rather own a handful of defensive names that take on characteristics like those of large-cap tech?

So, reluctant bulls and bears seeing the market moving against them got squeezed into areas of the market that were perceived as safer (even though appearing extended) – large-cap tech.

So, Where Do We Stand Today?

That expansion off the October lows continued through the first quarter of this year. Yes, mega-caps and the AI-adjacent plays were clearly leading the way, but the rest of the market was doing just fine, thank you. Through 3/29/24, the Magnificent 7* was up 17.1% while the rest of the market was up 9.3% – not too shabby. Rising tides lifted all boats as inflows piled into not just the mega-caps but into cyclicals and even defensives. However, there remains a significant absence of small-cap companies.

?But that’s where this so-called bearish divergence began to kick in. From 5/17 through 6/17, it’s been all about tech as the Mag 7 returned 11.9% while the rest of the S&P 500 was down 0.5%.

So, what changed? The Growth Outlook.

This is where the tug-of-war I keep mentioning between inflation fighting and keeping growth afloat remains. As we’ve written time and again, the consensus aggressively revised growth expectations higher and finally caught up with reality. But just as consensus has grown overly sanguine, we’ve started to see some softer data prints. Nothing overly concerning yet, but enough to help foster growing fears of a more pernicious slowdown. This is why I keep harping on the 10-year US Treasury yield. If rates fall too much, then the money is saying growth is declining too fast. This could preempt a recession.

Breadth has narrowed because investors are grappling with the prospect of slower growth, and that has shifted the bid back to those high-quality, wide-moat, mega-cap tech names.

The Bottom Line

Breadth has been healthy this year. Narrowing breadth has only begun to appear in the past month, and that’s a function of the narrative pendulum beginning to swing toward growth concerns. Have recent gains been driven by a handful of names? Sure. But guess what? That’s normal! Empirical evidence simply does not tend to corroborate poor market breadth and weak future returns. Yes, some breadth divergences have resolved with prices catching down to deteriorating breadth. But often, they resolve in the opposite direction with breadth eventually catching up to prices that continue to grind higher.

In the past few sessions, we’ve seen healthy rotations that can help to expand breadth as well:

·??????? Thursday, June 20th, marked an outside reversal day for NVDA – a day that saw the stock open above the prior day’s high, push higher, and then collapse lower and close below the prior day’s low

·??????? A classic technical marker of a potential trend reversal, just like the one we saw with NVDA at the onset of the March pullback

·??????? In just three trading sessions, NVDA pulled back just over 16%

·??????? But for all the fears of an unstable, narrow, and top-heavy market – that was only enough to push the S&P down a mere 1%

·??????? All the while, breadth has expanded, thanks to the rotations under the surface – an unwind out of overbought leaders rotating into relative laggards in cyclicals and defensives.

·??????? A healthy consolidation and rotation that mutes the index downside and wipes away those narrow breadth fears.

We might not be through the narrow market just yet, as the narrative pendulum likely needs to swing further toward growth fears in the coming weeks. The labor numbers from last Friday and the CPI and PPI numbers this week will certainly factor in. This suggests the potential for a pullback and continued narrow breadth as investors reprice the outlook and continue to favor quality names in large-cap tech.

Last week, which was shortened due to the holiday, was essentially more of the same. The Nasdaq was up by a couple of percent, and the S&P also posted gains, but most of the rest of what we saw was flat-to-down on the week.

Thus, from a top-down perspective, the evidence remains the same. The big-cap indexes are looking fine, and the rest of the market is doing nothing as it chops sideways. The significant change for the week was interest rates. Just when it seemed like they were spiking higher, they turned on a dime and moved back lower.

The heat of summer is on. Last week, I went over the statistics of what “usually” happens next. Will history rhyme and repeat itself, or, just like our current political battle, will it confuse and confound many? We will be ready to adjust as we see fit but be sensitive to the fact that volatility is a characteristic of a normal market, not an anomaly.

-Ken South, Newport Beach Financial Advisor

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Important Disclosures:

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

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