A Breadth of Air?

Posted on by Todd Hurlbut - CIO

The S&P 500 rebound from the March lows has been extraordinary by any measure but is it sustainable? Healthy, sustainable bull markets in stocks require broad participation, that is, most stocks should be participating in the uptrend. How does the current market breadth compare historically and what does it say about the health of the equity market? 

Strong bull markets are characterized by broad participation across market segments, i.e. not only are the largest stocks (Large Caps) doing well but so are the small and mid-sized stocks (Small and Mid-Caps). Typically, in the final stages of the equity market cycle, the Small and Mid-Cap stocks turn down first followed by the Large Caps. In 2007, the Small and Mid-Cap stocks peaked simultaneously in July of 2007 only to be followed by the Large Caps in October of 2007. Interestingly, all three segments bottomed on the same day, March 9, 2009, and from the depths of the Global Financial Crisis a new bull market was born. 

At this juncture in the current cycle, the Mid-Cap segment of the US equity market reached an all-time in the first quarter of this year. However, despite the rebound in stocks it is still down from the peak by nearly 10%. Further, the Mid-Cap Index remains below the levels achieved in January of 2018. In summary, the mid capitalization stocks in the United States peaked in 2020 but with this year’s decline are below the levels seen more than two and a half years ago.

S&P US Mid Cap 400 Index – Weekly 5-year chart (MID Index)  

Like the Mid-Cap Index, the Small Cap stock segment is 14% below the highs achieved in January and is more than 18% below the all-time high reached in August of 2018. With the decline in 2020, the Small Cap space is below the levels achieved in September of 2017 and therefore has made no progress in 3 years. 

S&P US Small Cap 600 Index – Weekly 5-year chart (SML Index)  

An additional way to view breadth across markets is thru tracking the number of stocks in an index that are trading above their respective 200-day moving averages. The 200-day moving average is used by many as a broad delineator of trend. When a stock is above the 200-day, the trend is up and vice versa. Like weakness across segments, when fewer constituents of an index are in an uptrend it can portend broad market weakness to come. Let us look at the S&P 500 market top in 2007 as an illustration.

On February 23, 2007, the number of stocks in the S&P 500 above their respective 200-day moving averages reached 90.91% (green vertical line). When the S&P 500 index finally peaked on October 12, 2007 only 61.49% (green vertical line) of stocks were above their 200-day demonstrating significant deterioration in market participation leading up to the final high. Deterioration of some magnitude is typical of market behavior near tops.

S&P 500 Index – Weekly 2yr chart (2007-2008) (SPX Index) w/ % of stocks above their 200-day MA

Looking to 2020, market breadth in the S&P 500 peaked at 87.40% on January 17th. The market, however, peaked on Valentine’s Day (green vertical line) where we had already seen some deterioration in the number of stocks above their 200 day moving averages at 80.40% (red declining trend line).

As the S&P 500 has sharply rebounded from the lows in March, the number of stocks above their respective 200 day moving averages remains stubbornly low. At the recent peak on August 28th (green vertical line), only 64.20% of S&P 500 constituents were in an uptrend demonstrating the bifurcation in today’s market between the narrow leadership and the rest of the market. 

S&P 500 Index – Weekly 2yr chart (2018-2020) (SPX Index) w/ % of stocks above their 200-day MA

As Michael A. Gayed from The Lead-Lag Report recently shared, “more than 60% of S&P 500 components are down since the S&P 500 hit its previous all-time high in February.”

A final way of observing market breadth is through tracking the number of stocks making new 52-week highs when the respective index is making new highs. In late July through August, as the S&P 500 was closing in on a new all-time high closing value, the number of stocks making new 52-week highs remained below 10% (green trend line). Compare that to January of this year when more than 25% of the stocks in the S&P 500 made new 52-week highs. 

S&P 500 Index – Weekly 1yr chart (2019-2020) (SPX Index) w/ % of stocks making 52-week highs

Market Breadth is a helpful tool in determining the health of the equity markets. While the S&P 500 looks vigorous on the surface, the health of the individual constituents and Small / Mid cap market Segments are telling a different story. A market indicator like breadth is not a robust signal in and of itself yet when the data diverge from the indices it can act as a red flag to instill caution. 

The indexing trend of the last two decades has acted to exacerbate the concentration of market gains in a narrow group of stocks. As stocks become larger in market capitalization, they represent larger components of the S&P 500 and must be bought in size to maintain index composition. When an investor buys an index fund, those additional funds disproportionately inflate the larger companies creating a perpetual feedback loop and the potential for stocks to become further disconnected from the reality of the underlying businesses. Taken to the extreme, if every investor is an indexer, there can be no price discovery. The pendulum has swung swiftly and decisively from active investment management to passive index investing. As the chief proponent of indexing John Bogle said “If everybody indexed, the only word you could use is chaos, catastrophe… The markets would fail.” At the conclusion of this cycle, the pendulum may well swing back presenting significant opportunity to investors looking to pick individual stocks and participate in price discovery. That would indeed be a breath of fresh air.