Stocks Have a Case of Bad Breadth - Economic News you can Use

It may not be halitosis, but something smells a bit in the stock market. While the market has experienced some down days recently, including the correction that blunted the bull market, in the longer term the market is sticking with its traditional solid growth pattern. However, there is a trend underlying that growth pattern that is worth watching.

Currently, a disproportionately low number of stocks are responsible for a sizable part of the market's growth. In other words, recent growth is not very broad. A fortunate few stocks are doing well while too many are losing ground.

That condition suggests underlying market weakness, since a majority of companies are actually losing value. USA Today notes a similar lack of breadth in 2000 that preceded the bursting of the dot-com bubble, and the growth stocks of the 1960's that preceded the bear market of 1973-1974.

Does this mean a bear market is imminent? Not at all, but it is worth looking a bit closer at details and trends within the market.

A Few Large Drivers

It's important to keep in mind that the major indices (Dow Jones Industrial, S&P 500, and NASDAQ) are all weighted, meaning that not all the stock prices are given equal weight when the index is calculated. By definition, some stocks are going to have a greater bearing on the index than others. For example, as of this writing, Apple (NASDAQ:AAPL) is the largest contributor to the S&P 500 at 3.66% and the NASDAQ 100 at 12.4%, and it is the eighth-largest contributor to the Dow Jones Industrial Index at 4.43%. That unequal distribution makes it important to consider market breadth as well as the actual index number.

One insightful way to look at breadth is the percentage of growth contributed by a handful of the largest stocks. Take the S&P 500 as an example. In 2013, the S&P 500 gained 422.2 points and the ten largest stocks accounted for 64.2 of those points, or 15.2% of the gains. In 2014, that percentage rose to 19%, with Apple providing over half that 19% all by itself. As of November 6th, the S&P had gained just 40.3 points for the year while the top ten stocks gained 42.9. That's 106.4% of the growth. In essence, the overall S&P 500 is down for the year without the largest stocks.

The change is even more evident when the categories are divided further. As of November 10th, the stock values of the 45 companies in the S&P 500 with market capitalization greater than $100 billion are up by an average of 8.5%. The 49 companies between $50 billion and $100 billion are up 1.4%, the 292 companies between $10 billion and $50 billion are down 0.5%, and the 118 companies worth less than $10 billion are averaging a 9.6% loss.

What are the stocks that buck the trend? Examples include Netflix (NASDAQ:NFLX) and Amazon (NASDAQ:AMZN), which have both more than doubled for the year as of this writing. Google's new parent company Alphabet (NASDAQ:GOOGL) is up over 35% and Microsoft (NASDAQ:MSFT) is up 13%. Apple had been at close to a 10% gain before tanking over the last few days.

All five are titans of the large market cap tech stocks (with the exception of Netflix at $46 billion), and all have price-to-earnings (P/E) ratios over 30 (with the exception of Apple at 12). Amazon's P/E ratio as of this writing is a staggering 931. Large cap stocks with high P/E's driving the market by themselves can lead to sharper index drops in the future, since there is no broad growth to counteract a large cap plunge.

The Relevance of Moving Averages

To analyze market breadth without daily noise, analysts often use 200-day moving averages in their calculations. Professionals have many variations on the theme — if you are interested, simply search the term "market breadth indicators" — but the simplest is to look at the 200-day moving average of all individual stocks on a particular exchange, and find the percentage of the listed stocks that are rising in value versus those that are dropping relative to the 200-day average. This is often called advancing versus declining stock ratios or something similar.

The New York Stock Exchange (NYSE) over the last two years has a daily average of just over 60% of stocks advancing with just under 40% declining. In the first 6 months of 2013, that value was hovering mostly between 75% to 85% advancing — excellent breadth. Since then, that value has been on a steady decline punctuated by a few swings. During the August correction, it dropped sharply from near 40% rising to 15% rising before climbing back to near 40% at the beginning of November. It is now below 29% rising stocks and headed south.

That doesn't necessarily herald another correction, but it does suggest the market isn't as strong as the index numbers would lead us to believe. A two-year trend of fewer companies beating their 200-day moving averages is not confidence inspiring, either.

Another Round of Overvaluation

While market breadth is dropping, overvaluation is increasing. The average P/E ratio of the S&P 500 is 16.8 based on estimated earnings over the next four quarters (otherwise called the forward P/E ratio). Historically, that average is around 14.6.

Values can rise because earnings are falling much faster than prices — for example, the average S&P 500 P/E ratio for 2009 was 70.91 based on the earnings drops during the Great Recession — but overvaluation is not a good sign in the face of a narrow market, a global economic slowdown, and an imminent interest rate hike by the Federal Reserve. That's a lot of forces working against growth.

The Takeaway

What does all this information add up to? It's the same message that we have been getting for some time: slow growth with occasional dips or corrections. At the moment, large cap stocks are driving the market, but that doesn't mean they will continue to do so. As you rebalance your portfolio, evaluate your individual stocks with an eye toward future earnings and performance.

Think of the current lack of market breadth as an opportunity to find undervalued stocks to replace the poorer performing stocks in your portfolios. Take a look at the fundamentals of the companies you are considering — P/E ratios, product projections, cash and debt positions, earnings forecasts, etc. — and make your decision based on the most promising prospects.

Don't forget to maintain the correct balance of risk, and don’t be tempted to go with all large cap stocks purely because they are doing well at the moment. Stick with diversity, because trends do not last.