Reach for the Scope: The "Bad Breadth" issue facing markets

Market breadth is a crucial metric in stock market analysis, offering valuable insights into the overall health and direction of the market. It measures the number of stocks participating in a market move, providing a clear picture of whether a rally or decline is widely supported or driven by a few key stocks. 

Strong market breadth, where a large number of stocks are advancing, suggests a robust and potentially sustainable uptrend. Conversely, if a market index is rising but only a few stocks are driving the gains while the majority are lagging or declining, it indicates weak market breadth and suggests the rally might not be sustainable.

One of the primary benefits of market breadth is its ability to confirm the strength of market trends. Indicators such as the advance-decline line, which tracks the cumulative difference between advancing and declining stocks, help investors gauge whether a bull market is healthy or if a bear market is weakening. 

For instance, in a healthy bull market, the advance-decline line should trend upwards along with market indices. If the market index rises but the advance-decline line falls, it could signal a weakening trend and potential reversal, providing investors with critical information to adjust their strategies accordingly.

Market breadth also serves as an early warning system for potential reversals and market risks. Divergences between market breadth indicators and price movements can signal that the market is losing momentum and may be due for a correction. Additionally, by examining market breadth within specific sectors or industries, investors can identify which areas of the market are leading or lagging, aiding in sector rotation strategies. 

Understanding market breadth helps investors manage risk, as periods of weak market breadth indicate higher risks of a market downturn, prompting more cautious investment approaches. In essence, market breadth analysis empowers investors to make more informed decisions, better manage their portfolios, and navigate market complexities with greater confidence.

Breadth Issues Facing the Markets

The recent performance of the U.S. stock market highlights significant market breadth issues, with a notable divergence between the performance of a few large-cap stocks, dubbed the Magnificent Seven, and the broader market. These seven stocks, which include tech giants like Apple ($AAPL(AAPL)), Nvidia ($NVDA(NVDA)), and Microsoft ($MSFT(MSFT)), have driven much of the market's gains, with Apple rising 8%, Nvidia up 9%, and Microsoft increasing by 4% last week alone. 

Percentage of Nasdaq stocks trading above the 50-day MA:

This concentration of gains has led the S&P 500 up by 1.50%, despite the Equal Weight S&P 500 index, which better represents the average stock, falling by 0.50%. This divergence indicates that while the index appears strong, the underlying market health is weaker.

Liz Ann Sonders, Chief Investment Strategist at Charles Schwab, pointed out that beneath the surface, the average stock in the Nasdaq has experienced a 37% drawdown, compared to the 7% maximum drawdown of the index from its year-to-date high. This suggests significant churn and rotation not visible when solely looking at index level changes. 

Further, the share of S&P 500 members trading above their 50-day moving average has dropped below 50%, while the index itself continues to trade above its intermediate-term average by more than 4%. Such divergences, last seen in December 1999 before the tech bubble burst, indicate potential market instability.

Percentage of S&P stocks trading above the 50-day MA:

The relative strength index (RSI) also underscores these divergences. For the first time since 1990, the traditional capitalization-weighted S&P 500 has outperformed the S&P 500 equal-weight index by 2 percentage points or more for two consecutive weeks. Jonathan Krinsky of BTIG highlighted that the RSI for the S&P 500 finished above 70, signaling an overbought condition, while the RSI for the equal-weight index remained below 50, indicating oversold conditions. This significant gap between momentum indicators highlights the bifurcation in the U.S. market, with a few large-cap stocks driving gains while the broader market lags.

Market breadth indicators show that only 17% of stocks in the S&P 500 ($SPY(SPY)) have outperformed the index over the past 30 days, despite the S&P and Nasdaq ($QQQ(QQQ)) making new highs. The Russell 2000 ($IWM(IWM)), representing small-cap stocks, continues to underperform, placing new lows in relative strength compared to the S&P 500 and remaining down 18% from its 2021 peak. This weakness in smaller stocks further accentuates the market's reliance on a few large-cap leaders, raising concerns about the sustainability of the current rally.

Despite these concerns, some positive signals remain. The AI sector, led by Nvidia, has shown significant growth, with Nvidia's stock surging 174% in 2024. This enthusiasm for AI-related equities has also boosted other chipmakers like Broadcom ($AVGO(AVGO)), which is up 61% this year. However, the broader market's dependence on a handful of stocks means that any downturn in these leaders could lead to a broader market correction. The S&P 500's cumulative advance-decline line has failed to make a new high alongside the index, indicating that the number of declining stocks continues to exceed advancing ones.

The divergence in market performance is partly driven by the Federal Reserve's actions, as the central bank has maintained higher interest rates to slow economic growth. These elevated rates have investors scrutinizing zombie companies, which constitute about 17% of all U.S. corporations. A zombie company is one where interest payments on debt exceed the net income generated by the business, making it unsustainable in the long term and potentially leading to bankruptcy. This financial instability makes investors hesitant to invest in such companies. In contrast, large tech companies, which generate substantial cash and have minimal debt, continue to perform well. This contrast is evident in the Russell 2000 index, where profitable stocks are outperforming non-profitable ones by approximately 18 percentage points year to date, potentially setting a record.

Conclusion

In summary, while the market indices, driven by a few large-cap stocks, present a picture of strength, the underlying market breadth reveals a more fragile and complex situation. The divergences between the performance of large-cap stocks and the broader market have not been seen since 1999, raising concerns about potential market instability. Investors should be cautious, monitoring these breadth indicators and considering the broader market context to make informed decisions.

Negative divergences in market breadth are not uncommon and can happen periodically. The current divergence has been present for only two weeks, meaning it could potentially resolve itself quickly. However, if this divergence persists for several months, it could indicate deeper market issues. Extended periods of negative divergences in market breadth can often lead to significant market declines.

The Fed's decisions regarding interest rates continue to influence market investment strategies. Concerns about zombie companies, which struggle under high debt, are driving investors toward safe haven tech stocks that are experiencing significant growth from their leadership in AI and carry little debt, making them less vulnerable to higher rates. However, if market dynamics shift and investors start moving into underperforming stocks, it could signal the next phase of a bull market. For now, it is crucial for investors to be cautious and closely monitor these market trends.