Market Breadth Portends Trouble Ahead; Tech in Crosshairs?

Market Breadth – the degree to which all companies in an index contribute to index returns – has been on the decline and is now reaching extremes. Stocks returns tend to be weaker-than-average with deeper declines, when following a sharp narrowing of breadth.

The chart below shows the market performance of the S&P Small Cap 600 and the Russell 2000 small cap index. During 2020, the broader Russell index performance was almost double the S&P 600 index.

The next chart shows the same two indexes for YTD 2021. What a difference! The S&P 600 performance is more than double the broader Russell 2000 index. Why the big swings? The reason is that when looking at the components of the Russell index, about 40% of the stock in that index do not make money, i.e., more speculative stocks. By contrast, profitability is a prerequisite for inclusion into the S&P 600.

From the first week of February 2021, the profitable S&P 600 is up 4.2%, while the 40% unprofitable Russell 2000 is down 6.5%. That is a sharp narrowing of breadth.

We also came across a report from Goldman Sachs discussing an even more extreme circumstance in the S&P 500 index. According to Goldman, the top 5 (or 1%) of companies in the S&P 500 have produced 35% of the total index return thus far in 2021 and 51% of the index returns since April. (See table below)

Goldman notes that following periods of sharply narrowing market breadth, like we are experiencing now, stocks have historically exhibited weaker-than-average returns and deeper drawdowns.

The chart below, also from Goldman, shows a measure of market breadth (a lower number = narrower breadth). When breadth is very poor, market turbulence has typically not been far behind.

Examples: the 2007 trough followed by the Housing crisis in 2008; Dec. 2011 coincided with a market bottom; and Sept, 2018 which was followed by a sharp 3-month correction.

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By: thinkhouse