Weekly Perspective: Up There Where the Air is Rarefied- Fading Breadth at All-Time Highs
U.S. large cap equities are flying away in thin air.
The S&P 500 had its 33rd day in 2021 closing at an all-time high last week, though since April, a declining number of stocks have been joining in on the new-high party.
This narrow participation in the rally increases the risk for volatility and a pullback in equity markets in the near term.
Chart 1 shows that since April, a falling number of S&P 500 members are trading above their own 50-day moving averages. This means that the new highs in the market are relying on strength in a narrowing sub-set of names. This divergence with price and breadth can make the rally more fragile, and thus our call for heightened volatility through the summer.
Low breadth is not always a problem for forward returns, as it can be a contrarian buy signal at the end of a correction. But this fall in breadth is peculiar as it is happening while the market is making new all-time highs. Chart 2 from Bloomberg shows that the S&P 500 now has the lowest percentage of stocks above their 50-day moving average when the market hits at a record since 1999. Hardly supportive of angels’ cheers.
When we peel back the layers of this decline in breadth, we can see what is driving this divergence.
Table 1 shows the breadth readings of each S&P 500 sector.
Table 1: U.S. Equity market Performance
|Index Name||% of Members Above
Their 50 Day Moving
Source: Bloomberg, Fieldpoint Private
Unsurprisingly, we can see that areas of the market that have been strong relative performers of late, Real Estate and Energy, continue to sport high breadth numbers, meaning broad participation in these rallies. Also unsurprisingly, areas of continued underperformance, like Consumer Staples and Utilities, have low breadth numbers.
But what is notable is the weak breadth in sectors that were reopening, cyclical, and value darlings. Financials, Industrials, and Materials all have middling-to-low breadth readings, and their weakness appears to be the source of the falling breadth in the market.
This makes the timing of that April start of the decline in breadth in the market very interesting.
April was the peak 40-year high reading in the manufacturing Purchasing Managers Index (PMI). As we wrote in our April 5 piece on PMI contrarianism, very high readings in the PMI typically coincide with poor forward returns for cyclical equities because cyclical momentum is as good as it can get in the near term. So no surprise to see areas like Industrials have fading breadth as the rallies in cyclical names peter out.
The beginning of April also marked the recent peak in 10 Year Treasury yields, as well as the yield curve, so no surprise to see fading breadth in Financials either (the spread between the yields on 10 year and 2 year Treasuries is considered an important driver of bank profitability).
Over the past month, Materials breadth has collapsed to be one of the worst in the market, as commodities (ex-oil) have endured sharp sell-offs. We had been expecting corrections in commodity markets driven by stretched flows and positioning, as well as fading stimulus coming out of China. Chart 3 shows that China money supply growth leads commodity markets by 6 months.
So, with all this unwind in the cyclical parts of the market, what is driving the market to new all-time highs?
Well, we’re back to our old ways: Tech.
This is an important development, because in recent years we have seen Tech strongly outperform in times when economic growth is scarce (think 2014-2015 or 2019-2020). This is because many Tech names possess idiosyncratic growth drivers that can still generate attractive earnings growth even when broader economic growth is paltry.
So if Tech is breaking out and driving the upside to the market, could this be a sign of fading optimism about economic growth and a cyclical rebound? That is likely part of it, given we can observe the fading tailwind from both fiscal and monetary policy, which could be a drag on growth going forward. Chart 4 shows how the federal budget deficit as a percentage of GDP has bottomed, while Chart 5 and Chart 6 show the slowing in the growth of monetary policy support year-over-year (which is happening even if the Fed makes no change to its monetary policy stance). This fading momentum in policy should also contribute to higher equity volatility.
We also think that positioning got too one-sided and flows got too extreme into inflation-benefitting and cyclical assets. Everyone got on one side of the boat, so it is perfectly understandable to see some rebalancing, mostly when considering that positioning reached an extreme just as the data was peaking (Mr. Market strikes again).
But as we saw after 1999, a narrow cohort of high-flying names can’t sustain the market at all-time highs forever. Either a correction ensues or participation in the rally starts to broaden out again (which in this case would require a rebound in the cyclical trade).
So, along with seasonal headwinds and fading trading momentum, this weakening breadth supports our call for choppier/sideways trading in the summer, with a risk of a moderate correction. We continue to believe a correction of this magnitude does not warrant incurring gains taxes to raise cash balances, but does argue for patience in putting new capital to work in the equity market, waiting instead to take advantage of future volatility. We will look to stress in the credit markets to determine if this moderate volatility could turn into something necessitating a more aggressive reaction. For now, credit remains not just benign but at all time low spreads, so the underlying fundamentals remain strudy.
So while you’re being patient, why not enjoy some sweet tunes from Ol’ Blue Eyes as you get those “shopping lists” ready.
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