Bad Breadth

Market Update for the Quarter Ending
June 30, 2023

The “breadth” of the market is a term used to describe the general participation of all companies within a market index, such as the S&P 500. Market breadth is an indication of the number of stocks that are rising in price relative to those that are falling in price. The term has become a signal of market health. It is generally considered positive to have a greater number of companies participating in a stock market rally. Contrarily, it is widely believed to be a red flag when an index is rallying due to only a small number of companies or sectors, as is the case so far this year with just a few mega tech companies pulling markets higher.

But how can an index be dragged higher due to only a small group of companies? The answer lies in a technical way in which the index is calculated. The S&P 500 is a capitalization weighted index, meaning the largest companies (and those stocks that have increased the most in recent years) comprise a larger percentage of the index. For instance, Apple and Microsoft account for approximately 7.7% and 6.8% of the S&P 500 as of June 30th. Add Amazon, Nvidia, Alphabet, Tesla, and Meta – all big winners this year, and the largest 7 companies represent about 27% of the S&P 500 Index.

The S&P 500 returned 8.7% during the quarter and 16.9% over the first 6 months of the year. Contrarily, the Equally Weighted S&P 500, where each company accounts for 0.2% equally, increased less than half as much at 4.0% for the quarter and 7.0% during the first half of the year. The 10% difference between the traditional capitalization weighted index and the equally weighted index is about the largest on record for such a short period of time.

This implies that the market rally has been quite narrow with a lack of broad participation of individual companies and sectors – also known as bad market breadth. But, is this an ominous sign, as some headlines would lead us to believe? What does this say about future returns? After all, if there are only a few ways to win and most stocks are underperforming, the odds of winning become less.

It is true that a rising market fueled with more expansive breadth (broad participation) is a stronger market. More stocks and sectors would be participating in the gains and outperforming. However, this is a past indication of strength. Most stocks will have already increased.

According to Fidelity, since 1928, the S&P 500 has returned 9% in the 12 months after top-quartile periods of market breadth (extreme expansive breadth). However, during this same timeframe, the S&P 500 has returned 16% in the 12 months after bottom-quartile periods of market breadth (extreme narrow/bad breadth). In other words, market breadth is a contrarian indicator. Bad market breadth, as we have seen so far this year, actually leads to better forward returns historically. In fact, about 80% of the time in which market breadth has been in the bottom quartile, market breadth has eventually broadened out, and more stocks have ended up participating in an already advancing index over the coming 12 months. What lies ahead this time remains to be seen, but we are already at extreme levels of bad breadth[1].

Large companies lead the way

As mentioned, the larger companies have outperformed during the first half of the year, led mostly by a select few mega cap technology companies. The domestic Russell 2000 Small Company Index increased 5.2% during the quarter and 7.0% in the first 6 months. Small and mid-sized companies started out strong but faded during the banking turmoil of March and early April and have not fully recovered. Smaller companies are quite inexpensive based on historical valuation trends and relative to larger companies.

Amid a Eurozone recession, the MSCI EAFE Developed International Index increased 3.0% during the quarter and 11.7% during the first half of the year. Similar to smaller companies in the U.S., the valuation of developed international companies is quite attractive. The MSCI Emerging Markets Index increased 0.9% in the quarter and 4.9% during the first 6 months. The China reopening theme after a near-3 year shut down has not played out as many expected and growth has continued to be slow.

Bonds have performed well over the last 9 months but have been relatively flat since interest rates bottomed out in early April. Rates steadily climbed throughout the quarter on the heels of relatively strong economic data, giving the Federal Reserve the green light to push the fed funds rate higher – although more recent favorable inflation data could offset this rising interest rate trend. The US Aggregate Bond Index declined 0.8% during the quarter but increased 2.1% over the first six months of the year. We expect interest rates to be volatile, but yields are dramatically higher than 12-18 months ago and should offset further interest rate moves higher.

Economy and earnings stronger than anticipated

The U.S. is going to have another recession someday, but it does not appear that it will happen this year given economic growth and near-record low unemployment and a consumer that continues to spend. Various economic reports suggest the economy is stronger than many realize, and inflation has slowed dramatically over the last year as we move away from the pandemic aftershocks. The Consumer Price Index climbed 3% in June from a year earlier, yet remains above the Fed’s 2% target. This could allow for possibly one or two more quarter-point rate hikes this year before an indefinite Fed pause. The economy has taken the 15-month rate hiking cycle in stride and may continue to grow. The Fed may get its cake and eat it, too.

Of course, we find it much more meaningful to study the corporate earnings levels and trends to stay ahead of the herd. We expect second quarter earnings to decline by close to 7% year-over-year, which would mark the third straight quarter of earnings declines. But the level of earnings has been stronger than many believed just months ago. The fourth quarter should provide a solid backstop to earnings since it was the beginning of the earnings weakness in 2022. Then, earnings should start to grow again. 2024 earnings will start to become more important, as investors are forward-looking. FactSet projects 2024 earnings growth of close to 12% – and this is what is providing the most support to financial markets at this time.

Global Asset Allocation Strategy

No changes have been made in early 2023. However, substantial changes were made in the fourth quarter of 2022 to set up portfolios for this year. Equities remain slightly overweight due to additions centered in domestic small and mid-sized companies at the October market bottom. Smaller companies have rallied yet continue to be the most attractive asset class given that valuation is 18-20% below median levels of the last 20 years based on forward earnings and book value. Smaller companies have outperformed relative to larger companies in May and June, and we would expect this trend to continue if market breadth broadens out from extreme levels.

Bond duration was extended near peak rates back in October and again in December. Longer-term, high-quality bonds can be defensive in slower growth environments. It was in late 2022 that we completely exited the “bond alternatives” that were held throughout the year to mitigate rising interest rates and the worst year on record for bonds. We continue to favor high quality bonds with yields across the portfolio ranging from 5-6%. There is very little exposure to lower-rated credits that tend to correlate with equities.

Cash levels are higher than usual given that money markets are yielding nearly 5.0% – and poised to be higher if the Fed increases rates later this month as expected. We continually try to sweep money into higher yielding money markets. If we see further market strength, we may try to replenish this cash.

Focused Equity Strategy

The second quarter was the season of “AI”, or artificial intelligence. Artificial intelligence has been around for a long time, going under various rubrics such as “machine learning”, “deep learning”, “algorithmic”, among other labels. However, the ChatGPT AI chatbot gained a lot of publicity this year, after which Microsoft promptly made a splash by investing billions and integrating it into its Bing search engine.

The AI euphoria pulled technology higher in the second quarter and during the first half of the year. Semiconductor stocks in general did very well in the quarter, with excitement over AI pulling up various semiconductor equipment stocks. The strategy’s exposure to semiconductors was ramped up in 2022 when the sector had a substantial pullback and is now close to double the broad market index after the recent recovery. We are currently evaluating these positions and considering a rebalance to reduce exposure in instances where valuation has become less than favorable.

During the quarter, we took the opportunity to realize some tax losses in bank holdings. We sold Wells Fargo (WFC) and US Bancorp (USB), and we used the proceeds to buy Truist (TFC), Fifth Third (FITB) and Huntington (HBAN). The banking stocks purchased are very similar to the banks that were sold, though without the regulatory baggage of Wells Fargo, and a little smaller and more regional to be more opportunistic. Banks remain attractive from a valuation standpoint and exposure remains in-line with the market. While there are many good and bad customer service stories about every bank, investments in banks are primarily about monitoring the quality of their balance sheets and net interest spreads. In any interest rate environment, rising or falling, the mix and quality of loans and bonds (assets) and deposits (liabilities) is a key determinant in the valuation.

Aside from select technology and semiconductor names that have pushed higher, we are always looking to trim (or sell) positions that have become overweight within the strategy. Likewise, we are constantly searching for undervalued companies that have the potential to outperform over the next 5-7 years. As with banking transactions taken during the quarter, we always consider tax implications of each trade.

Equities push higher

Equities have rallied close to 25% off the October lows. At that point, investors were expecting a bigger hit to earnings that so far has not materialized. As we have stated in prior newsletters, financial markets tend to hit bottom 11 months prior to the earnings trough. We feel that earnings could bottom out later this year and start growing again by 2024.

Upside likely resides in the cheaper cyclicals and smaller companies that have lagged mega tech companies in recent months. This would make sense if the market breadth finally broadens out to include small and mid-sized companies, and we suspect it will eventually. The economic backdrop would be favorable if current employment conditions persist, and inflation settles in closer to the Fed’s 2% target. This would be the scenario that allows equities to approach January 2022 levels once again. Fixed income would likely also perform quite well in such a scenario given that rates could level out.

As always, please contact us with any questions. We would be more than happy to discuss financial markets in greater detail, along with the implications to your personal financial plan.

The APW Team

[1] Fidelity Market Insights Podcast recorded May 30, 2023 and uploaded June 16, 2023