The stock market is not a democracy. But observers are still keen to warn in solemn terms that a lack of broad participation by a majority of constituents could create a leadership crisis. Indeed, investors are once again concerned by the relative narrowness of the index’s recent rally. The S&P 500 is just 1.2% from its all-time high, but only 60% of its constituents are up year-to-date, and just over 40% were above their 50-day moving average last week. .SPX YTD S&P 500, 1 year In recent years, it seems we are going through one of those periods every few months where we lament the lack of market breadth. The term “Magnificent Seven” was coined after these giant growth leaders dominated market returns last year in the wake of the collapse of SVB Financial and the credit scare. In an ideal tape, the rally would be broad and inclusive if only because a preponderance of rising stocks means strong demand for equity exposure and a sense that fundamentals and financial conditions are improving across the board. But does the evidence suggest that a more selective tape, supported by a relatively small number of big winners, is inherently riskier or more prone to market mishaps? Does breadth matter? It’s not entirely clear that this is the case. Bespoke Investment Group last week looked at a handful of past instances in which the S&P 500 was very close to its all-time high, yet most stocks were below their 50-day average. The index rose one to six months later more than 70% of the time. The subsequent one-year returns were below average, with performance ranging from a 19% increase to a 13% decrease. In bull markets, breadth divergences often resolve to the upside, with most stocks recovering and coming in line with the index, but this is by no means guaranteed. Last year, as this chart shows, a very similar pattern of internal momentum weakening began around mid-year, before a broader rally propelled the S&P to new highs over the summer (reaching a mini-peak at the end of July, then correcting). Warren Pais, founder of 3Fourteen Research, analyzed market behavior after other situations that have surfaced in the past week or so, including the Hindenburg Omen (an extreme build-up of new 52-week highs and lows) and the nasty downturn after the S&P’s top three stock Nvidia’s earnings report (the index rose 9% but then fell 1% on the day). Nothing is more clear than an unambiguous strategy, but the incidence of significant corrections in the months that followed was consistently higher than normal. However, Pais chose not to recommend reducing equity exposure in response, noting that “sentiment and positioning are not similar to the market peak” and that “earnings ranges are expanding and momentum signals from earlier in the year remain intact.” The NVIDIA Impact The market’s volatile and erratic movements last week were quite telling of two clear trends in the current operating environment: Nvidia’s unusual, almost idiosyncratic behavior and the way the stock market is metabolizing the recent movement in Treasury yields. Of the $4.2 trillion increase in the market value of the S&P 500 since the start of the year, Nvidia (now with a 6.2% weighting) has contributed $1.5 trillion on its own, more than one-third of the total. The stock regularly trades at dollar levels equivalent to several times the sales of Microsoft, Apple, Tesla, and Amazon. It is regularly the most active call option contract. GraniteShares 2X Long NVDA ETF (which returns twice the daily movement of Nvidia stock) has seen assets soar to $2.8 billion from $200 million five months ago. The high-velocity inflows and outflows of money into the world’s third-largest stock by market capitalization, 120% more volatile than the S&P 500 itself, are the formula for unusual volatility and asynchronous movements between the index and most stocks. According to CNBC’s Data & Analytics Group, the 100-day correlation between the S&P 500 and the Dow Jones Industrial Average has reached its lowest level since the collapse of the dot-com bubble in the early 2000s.Of course, the Dow doesn’t include NVIDIA. Whether the concentration of energy and capital in one stock is a good thing, a dangerous thing, or just the way it is is up to you to decide. Certainly, the excitement around NVIDIA and a handful of companies that are direct beneficiaries of AI and industrial infrastructure buildout reflects a current lack of strong fundamental conviction. The impact of interest rates This is where the Treasury yield factor comes in. When yields rise, as they have for the past two weeks since May 15 (backed by robust inflation, robust growth, and a closely-patient, data-dependent Federal Reserve), most stocks fall and capital moves into the big long-term growth names that are not subject to macroeconomic volatility or capital costs. Banks and small caps fall, and consumer cyclicals get squeezed. The way this market gets defensive is by inflating the premium of the perceived new economy winners. These are also the most expensive, fastest growing, and most competitive names in the market. The sharp one-day sell-offs of both Salesforce.com and Dell Technologies after their earnings releases suggest that investors are under-leveraging the AI building boom (at least that’s the knee-jerk reaction of investors), reinforcing the herd’s urge to retreat into narrow pockets of secular themes deemed safe. Citi equity strategist Scott Chronert suggested all of this is on display on Friday, saying, “Part of the market may be relying on consistent above-expected earnings and upside dynamics throughout the year to justify current prices. At the index level, rising interest rates year-to-date have intensified this pressure from a cross-asset valuation lens. Importantly, however, the modest ~2% pullback from the month-to-date highs has occurred in tandem with rising FY24 EPS expectations, which are now in line with our forecasts. We view this as healthy price movement, squashing the enthusiasm where prices are still above strong fundamental trends.” Indeed, as this chart from UBS shows, 2024 earnings expectations have been unusually strong in recent months, avoiding the usual downward revision trajectory. When yields retreat, as they did last Thursday and Friday, in part due to weak PCE inflation, breadth improves, financials, cyclicals and small caps take comfort, and hopes of a broader earnings recovery and perhaps a Fed rate cut back most ships. Tape Update In the final 15 minutes of trading on Friday, as if the machines had heard enough about the worrying breadth narrowness, indiscriminate buying pushed nearly every stock vertically, with the S&P 500 up 0.8%, with 80% of all constituents rising and the weekly index decline narrowing to just 0.5%. This was undoubtedly a mechanical operation related to the cleanup of end-of-month reallocations and the massive quarterly rebalancing of MSCI indexes, which trade mostly at the close. This does not mean that the measures were unjustified or overdone, just that they will need to be tested by human decision makers as June begins. In summary, after a historic seven-month sprint, two months of near-already highs and a largely slumping market with most stocks in a stealth reset. Earnings and a still-expanding economy are key support. Credit indicators are mostly flashing green. Traditional defensive sectors like consumer staples and pharmaceuticals are lackluster, showing decent macro messaging. At its peak, the S&P 500 hit 21x expected earnings, a number it has rarely traded higher than that, except for the pandemic melt-up and tech boom/bubble a quarter century ago. Investor sentiment and positioning may not be as frighteningly extreme, but it is filling up rather than disappearing with the April pullback. Also, the range of data bulls can accept is not as wide, requiring further deflation before the economic slowdown tips into stall speed. Given this, it would not be surprising if a combination of time, softer stock prices, and rising earnings outlooks (are we already starting to trade on mid-year-to-2025 forecasts?) was needed for the tape to update.
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