In September of 2020, I wrote a blog called “A Breadth of Air” observing the deteriorating market breadth in the uptrend of the overall stock market. The market breadth further eroded into 2021 setting the stage for a bear market in 2022. Unusually, here in 2023 we are revisiting a similar, yet arguably worse, scenario.
Healthy stock market uptrends are present when most stocks are rising alongside the market averages. Conversely, narrow market breadth implies that a small subset of stocks are responsible for the majority of the index’s movement. In recent months, the S&P 500 has witnessed an increasing concentration of performance within a select few companies, giving rise to concerns about the sustainability of the market’s upward trajectory. The narrow market breadth of the S&P 500 poses challenges for investors. Firstly, it heightens the risk of overreliance on a limited number of stocks. If these companies encounter headwinds or experience a downturn, the entire index becomes vulnerable to a significant decline. The narrowing market breadth can also lead to distorted market valuations. When a select group of stocks disproportionately drives the index’s performance, their elevated valuations may not necessarily be reflective of the broader market reality. This phenomenon is particularly evident in technology, where a few high-profile companies have experienced exponential growth, leading to stretched valuations.
Second, such imbalances can create a disconnect between stock prices and their underlying fundamentals, increasing the risk of a market correction. The underperformance of a considerable number of stocks within the index is a warning sign of underlying weaknesses or vulnerabilities in the broader economy. We can see graphical evidence in a chart of the S&P 500 Index (blue line) versus the equal weight S&P 500 (green line). The dispersion in performance, the most acute since early March, demonstrates the outsized impact of a few large companies. Concurrently, the market breadth in the S&P 500 has severely narrowed to the extent that only eight stocks are responsible for the entirety of the gain in the index year to date. The remaining 492 stocks are collectively down on the year. As the S&P 500 Index is market cap weighted, the largest companies by market capitalization are disproportionately overweight the smallest companies; this tends to occur at the tail end of a bull market.
S&P 500 Index (blue) / S&P 500 Index Equal Weight (green) – 6-month Daily Chart
Narrowing market breadth is also evident in the number of stocks in an underlying index that are in an uptrend, by our measure above their respective 200 day moving averages. Despite the positive performance in the S&P 500 in 2023, barely half of the stocks in the index are above their 200 day moving averages as seen the in chart below. Nearly 80% of stocks were in an uptrend as recently as January of this year; this reversal demonstrates the severe degradation in the last few months.
S&P 500 Index & percentage of stocks in the Index above their 200-day moving averages (blue) – 6-month daily chart
In a previous post, “History Doesn’t Repeat Itself, but It Often Rhymes”, I outlined the typical pattern for when the stock market enters a bear market. First the small-cap stocks experience weakness and begin to decline, followed by the mid-cap stocks. Simultaneously, market breadth begins to narrow as fewer stocks are driving the market indices higher. Finally, the last stocks standing are the large-cap leaders which eventually succumb to selling pressure as fear takes over investor behavior.
In 2023, the small and mid-cap companies had briefly turned up, seemingly on the path towards a new bull market, but have in recent weeks resumed their downtrends with the Standard and Poor’s Small and Mid-Cap indices below their respective 200-day moving averages. The Russell 200 Index, a broad measure of small capitalization companies, has severely underperformed the S&P 500 Index as seen in the chart below, which further demonstrates the divergence and narrowing of breadth in the US stock market.
S&P 500 Index (blue) / Russell 2000 Index (green) – 6-month daily chart
The narrow market breadth of the S&P 500 index is a trend that demands attention and careful consideration. A healthy market requires a broader participation of stocks, promoting resilience, and reducing the risks posed by an overreliance on a small subset of companies. While the broader market may catch up to the few large-cap leaders, a more likely scenario is a resumption in the downtrend of stock prices.