What Is Market Breadth Telling Us About Future Returns?

6.28.2023 Credit AI, or a technical bounce, 2023 has been a blockbuster year for a small handful of mega-cap tech stocks. Since the beginning of the year, chipmaker Nvidia has surged 188 per cent, while Meta and Tesla have each doubled in value. Thirteen stocks have surged more than 50 per cent for the year, including Amazon, which is up 54 per cent. Despite the headlines, only about a quarter of the stocks in the S&P 500 are outpacing the index this year, leaving investors to wonder whether, without broader participation, the market is vulnerable to a pullback?

Breadth, or the diffusion of performance, is a widely watched technical indicator thought to gauge the relative importance of a market move. Technicians argue that a rally with broad participation is more meaningful than a rally shouldered by only a handful of stocks. We evaluated the S&P 500 by sector and by individual holdings to determine if breadth offers clues to the market’s subsequent direction. Among the 11 economic sector groups, we tallied how many outperformed the S&P 500 Index over the previous three months to gauge breadth. The fewer the sectors, the weaker the breadth. We discovered that neither extremely broad nor extremely narrow markets were conducive to further gains. Three or fewer sectors led to zero or negative S&P returns over the subsequent three months, on average, while eight or nine outperforming sectors similarly led to disappointing future results. The best results were delivered when four sectors outpaced the index over the previous three months – where we are today – subsequently returning 4.2 per cent on average over the next three months.

We also evaluated the three-month return differential between the capitalization-weighted S&P 500, where the largest companies have the biggest share of the index, versus an equal-weighted index in which every stock is 1/500^th of the index, and looked for extremes. As of the beginning of June, the capitalization-weighted index had outpaced the equal-weighted index by over ten percentage points for the year, an extreme level that points to narrow breadth.

This phenomenon reminds us of two other periods when a narrow swath of the largest stocks led the market: 2020, at the outset of the pandemic-induced lockdowns; and the tech bubble of 2000. In a market that tends to be mean-reverting, the average stock subsequently outpaced the largest stocks in the aftermath of these extreme conditions.

• At the height of the pandemic at the end of March 2020, the cap-weighted S&P 500 outpaced the average stock in the market by over six percentage points for the month, as investors scrambled to buy the largest, most stable companies. However, from the March bottom to the end of that year, the average stock surged more than 80 per cent, outpacing the cap-weighted index by over 10 percentage points.
• A similar phenomenon occurred in the aftermath of the tech bubble of 2000. Between 2000 and 2001, the equally weighted S&P gained 6.4 per cent despite the S&P 500 losing nearly 20 per cent of its value. We highlight that the equal-weight index is substantially different than the cap-weighted S&P 500, most notably in their respective technology weightings. Tech represents more than 27 per cent of the S&P 500, yet only slightly more than 11 per cent in the equal-weight index. Apple, in a striking example, comprises 7.6 per cent of the S&P 500 and only 0.22% of the equal weight strategy.

Bottom Line: Our study shows the return of the average stock benefits after periods when the S&P 500’s returns are highly concentrated in a handful of names. Given the narrowness of the market so far this year, we suggest investors consider an S&P equal-weight strategy or US mid-caps for cash earmarked for US large caps. History suggests this trade will play out over the next 12 months.