Runaway Stock Market: Does Breadth Matter?
Most likely, had you asked an investor during the spring for a market forecast given the summer scenario of fresh highs in new COVID-19 cases accompanied by double-digit unemployment and the worst ever quarterly drop in Gross Domestic Product, you would not have been surprised to get a bearish response. Here we are, however, hovering at all-time highs in the S&P 500 Index. As SentimenTrader has recently documented, we are witnessing historic discrepancies in sentiment, with some market participants outright euphoric and others stubbornly bearish. My work with portfolio managers and traders reveals similar ambivalence.
One of the most commonly cited concerns regarding the recent market strength has been its narrow base. In an excellent overview, Barry Ritholtz notes that the six “FAANMG” stocks (Facebook, Apple AAPL , Amazon AMZN , Netflix NFLX , Microsoft MSFT , and Google) now account for over 27% of the total capitalization of the S&P 500 Index. That is the most concentrated market since the 1960s. Still, Ritholtz notes, similarly high levels of market concentration have not automatically led to poor longer-term returns. Yes, when we had high levels of concentration in 1980 and in the late 1990s and 2000, we saw market corrections. These, however, were eventually eclipsed over the subsequent decade.
A different view on recent weak market breadth comes from a look at the chart of an equal-weighted version of the S&P 500 Index (RSP) RSP versus the standard chart of the weighted index (SPY) SPY . While the latter is at the all time highs, the former is not only below its February peak, but also below its June bounce off the March lows. Similarly, growth stocks within the S&P 500 universe (VOOG) VOOG have roared above their February peaks, while value stocks (VOOV) VOOV remain below those June and February highs. While the S&P 500 Index made a closing high for this rally on Friday, only about 6% of stocks in that universe registered a fresh 52-week high, according to Index Indicators. Even for the very strong NASDAQ 100 Index, the number of new highs on Friday was only 12. And for the S&P 600 Small Cap stock index? Less than 3% of component stocks made new annual highs on Friday. Across the entire NYSE universe, according to Rob Hanna of Quantifiable Edges, only 65 stocks registered new annual highs on Friday, well below February’s reading of 345. It’s indeed been a narrow rally.
What if, however, the important variable for the market rally is not the absence of fresh strength but the presence of new weakness? Rennie Yang at Market Tells noted on Friday that the number of stocks making fresh annual lows across the NYSE universe hit its highest level since May, a phenomenon associated with weak returns over the short term. My own tracking of stocks across all indexes making fresh one-month and three-month lows, taken from the Barchart site, finds that Friday’s numbers were unusually weak, with 220 one-month highs and 592 new monthly lows. This is surprising, since the overall market has moved nicely higher over the past month. (Also interesting is the fact that new three-month lows registered their highest level on Friday since May).
Does the expansion of new lows in a strong market index period portend weakness? If we go back to March of 2000, a period somewhat similar to the current one with unusual strength in tech stocks, we find that, as the market peaked, we commonly saw hundreds of stocks making new yearly lows. Indeed, the days immediately preceding and following the late March price peak were days in which new annual lows outnumbered new highs. That same pattern was seen as the overall market peaked in October and December, 2007 prior to the 2008 bear market. Even at the February, 2020 peak prior to the market’s pandemic swoon, we saw dozens of stocks making fresh annual lows. Quite simply, it appears that general market weakness is often preceded by weakness in one or more stock sectors, reflecting economic concerns that have not yet filtered through to the general economy.
I went to my database with data from Barchart and examined all market periods since 2010 in which the S&P 500 Index (SPY) had risen more than 5% in the past month. I then divided the sample into quartiles based upon the number of stocks across all equity exchanges making new monthly lows. When new monthly lows were at their highest quartile levels, the average return over the next 10 and 20 trading sessions was subnormal at -.98% and +.10% respectively. That compares with 10 and 20-day average returns for the remainder of the sample of +.66% and +1.66%.
To be sure, the expansion of new lows in a strong index environment is at most a yellow caution signal for the market and not necessarily a bearish red light. As noted earlier, we saw expanded new lows for months prior to the 2008 bear market. Too, as Ivaylo Ivanov has recently noted, the presence of weak breadth can occur in a rotational environment. The recent appearance of new lows, however, has me looking carefully at the sectors of the market that have been relative laggards, such as the value stocks and smaller cap shares. Will we see them pick up a bid on a broadened market rally or will they continue weak—and perhaps weigh on other sectors—in a market losing upside momentum? Like a good magician, the market makes us look at the hand that is moving: those FAANMG stocks. Where the real trick might be unfolding, however, might be in that other hand.