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Through the first quarter and the first day of the second, the S&P 500 is higher by 7.46%. On the surface, that’s good news for advisors and clients alike. After all, 2022 was an utterly forgettable year for both stocks and bonds.
If the conversation ends there, it looks like everything’s swell for risk asset to start 2023. Unfortunately, the “kids” (stocks) are not alright. Broadly speaking, that is. There’s potential problems on the horizon because, as was the case through so much of the prior bull market, a small number of stocks are leaders this year. In other words, market breadth was poor through the first three months of 2023.
Take the examples of Nvidia (NASDAQ: NVDA), Tesla (NASDAQ: TSLA) and Facebook parent Meta Platforms (NASDAQ: META). All three delivered stellar first-quarter showings, but that trio represents the fourth-, sixth- and ninth-largest members of the S&P 500.
For now, that’s great for investors owning those names and funds heavy on stocks doing the leading, but the fact is, the rally would be far more encouraging if there was broader participation.
Why It Matters
Many clients aren’t well-versed in the importance of market breadth. That’s why they have advisors and it’s a good thing, too, because while market breadth doesn’t qualify as “sexy” subject matter for many clients, advisors know it’s important.
One way of gauging strong or weak market breadth is to measure the performance of the S&P 500 Equal Weight Index against the cap-weighted equivalent. Some expert believe poor readings of the derived ratio between the two indexes can foreshadow bear markets.
“The ratio has plunged so far this year, eliminating much of the edge equal-weight had until recently. A short look back at the past two bear markets shows that a steep drawdown in this ratio is consistent with acute pain in the broader market. This time, it's much more about the outperformance of larger members as opposed to massive losses for the rest of the crowd,” notes Charles Schwab.
For reference, the Nvidia, Tesla and Meta example mentioned above is highly relevant because concentration risk is on the rise this year. Data confirm as much.
“The five largest stocks in the S&P 500 have dominated performance this year, with their average performance totaling +10.1% in January, -1.5% in February, and +14.4% in March. That is in stark contrast to the rest of the index, which saw an average move of +7.4% in January, -1.7% in February, and -0.5% in March,” adds Schwab.
Here’s a staggering statistic and one that doesn’t bode well for market breadth. As Schwab notes, just 10 stocks accounted for 90% of the S&P 500’s January through March upside.
More Participation Needed
An unsurprising result of a small number of stocks doing the heavy lifting this year is that a small number of sectors are contributing. The primary drivers of 2023 upside, to this point, are the tech, communications services and consumer discretionary sectors.
Yes, the banking crisis is an obvious reason for the laggard status of the financial services sector, but that shouldn’t preclude, say, healthcare or industrials from contributing more to this year’s equity market rebound. Said another way, the more breadth, the better.
“As investors learned last year, often the hard way, there can be pops in shorter-term breadth; but without confirmations from longer-term breadth, rallies have a tendency to ultimately fade. Strong outperformance from the "generals" (largest stocks) can power indexes higher, but a healthier market would be characterized by greater participation by the ‘soldiers,’” concludes Schwab.