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The Skinny on Breadth

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Tuesday, August 4, 2015
Money and Markets
The Skinny on Breadth
by Jon Markman

Dear ,

Jon Markman

In a follow-up to a column by my colleague Mike Burnick last week, I am taking a look at the important market topic. Technical analysts have been fretting a lot recently about the narrowing breadth of the market's recent advance, with the Nasdaq 100 essentially pushed to its new high a couple weeks ago by just a small handful of stocks.

To quantifying the issue, leave it to Jason Goepfert at Sundial Capital to come up with a good measurement. He points out that more than half of the stocks in the S&P 500 are already down by more than 10% from their 52-week highs. In essence, he says, the vaunted, long awaited, 10% decline has already been visited on a majority of stocks, but it just hasn't been reflected in indexes.

Click image for larger view

This is a remarkable number of stocks off 10% from their highs when you consider the S&P 500 itself was less than 3% from its 52-week high before it bottomed on Monday. To see how unusual this is, check out Goepfert's chart above. It shows the number of stocks in the S&P 500 that are 10% or more below their 52-week high while the S&P 500 index itself was within 3% of its own high. The current number is the highest since July 2000, Goepfert reports.

Nearly this many stocks had corrected in early 2012 as the S&P 500 recovered from its fall in the summer of 2011. Most stocks didn't recover as quickly as the S&P 500, causing a wide divergence.

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The other instances were more like our current scenario, with a minor pullback in the S&P 500 but large drops in nearly half of its component stocks. The ones that stick out of course are the occurrences as the bull markets peaked in 2000 and 2007. But big divergences also occurred well before those peaks, in early 1999 and mid-2006, respectively, according to Goepfert's data. It also occurred in late 1993, prior to a lackluster year in the S&P 500.

Goepfert notes that it is tempting to think, "Well, most stocks have already corrected, so that means the worst is behind us." That could still be the case, but based on history, the analyst notes it is more likely that the indexes have been masking real damage under the hood, and that is more likely to lead to weaker prices in the months ahead, particularly if leaders like Disney (DIS), Nike (NKE), Facebook (FB) and Google (GOOG) falter as much as Apple (AAPL), Biogen (BIIB), Intel (INTC), American Express (AXP), Caterpillar (CAT) and Walmart (WMT) already have.

* * *

For another point of view on this subject, let's turn to Jack Ablin, chief investment officer at BMO Private Bank. I have served on many Money Show panels with Jack and always respect his provocative points of view.

In a note to clients late last week, Ablin noted that a typical stock market cycle starts with cheap valuations and is sparked by an uptick in liquidity. Once embraced by the masses, momentum picks up until heady valuations emerge that giddy bulls struggle to justify. This mode then gives way to a loss of liquidity, faltering momentum and eventually a bear cycle.

The current bull market that began in early 2009 has witnessed more than a tripling in the S&P 500. Valuations were compelling six years ago. The index was trading at a price-to-revenue multiple below 1.0, a 50% discount to its historical median. The Federal Reserve provided an enormous liquidity boost, prodding investors to speculate. Momentum broke out convincingly by summer 2009, Ablin recalls, and the market has chugged higher since, with the exception of a 2011 hiccup.

Now Ablin argues that valuations look stretched. The S&P 500 is trading at a 25% premium to its historical median price-to-sales ratio and the Federal Reserve will soon start to withdraw liquidity.

The problem is that the market is being boosted by a narrowing list of very large companies, as we have discussed before. You know my view: The market is trading just below all-time highs because a few companies like, Google, Starbucks and Netflix are racing higher. They are more the exception than the rule.

Click image for larger view

Ablin notes that only 35% of NYSE-listed stocks are trading above their respective 200-day moving averages. The bulk are like Procter & Gamble (PG), shown above, or American Express (AXP) or Caterpillar (CAT), sinking into their own private bearish cycles. The NYSE advance-decline line, representing the difference between those stocks moving higher versus those losing ground, is at its lowest level since 2010. This display of narrowing breadth had preceded many market smackdowns in the past.

There are lots of ways to measure market breadth. One is to compare the market cap-weighted S&P 500, an index that is dominated by Apple, Microsoft, and Disney, with the S&P 500 Equal Weight Index (RSP), which gives the same weight to the 500th largest corporation as it does to a super-sized firm like Apple.

In periods of consolidation, or weakening internals, the traditional S&P 500 will beat the average stock as investors flock to a narrowing list of companies that are showing resilience, such as Gilead. However, both the regular S&P 500 and the equally weighted version topped out in May, Ablin notes, falling 1.1% and 3.7%, respectively.

This suggests that, although the stock market looks like it is chopping sideways, many stocks that are not household names have been rolling over. Ablin is holding his equity allocation at normal levels for now, but says that if he reduces his stock holdings this year, it will likely be because the few remaining leaders soften, busting the momentum story.

This is the right paradigm through which to look at the current environment. While the big indexes are standing firm, a tremendous number of companies are struggling. As practical investors, it is incumbent on us to stick to those few remaining upright soldiers before turning our attention in earnest to the short side once these last holdouts lay down their arms.

Best wishes,

Jon Markman

The investment strategy and opinions expressed in this article are those of the author's and do not necessarily reflect those of any other editor at Weiss Research or the company as a whole.

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