Does the U.S. Equity Market Suffer From “Bad Breadth”?

Market Concentration

Mega-Cap Tech Stocks Dominate S&P 500 Performance

One of the most talked about themes in the U.S. equity markets in 2023 has been market concentration. Simply put, the strong performance of the S&P 500 Index has been dominated by a small number of mega-cap technology stocks.

Name	Average S&P 500 Weight	YTD Return Thru Q2 2023	Contribution to S&P 500 Return
APPLE INC (AAPL)	6.9%	50%	3.01%
MICROSOFT CORP (MSFT)	6.1%	43%	2.40%
NVIDIA CORP (NVDA)	1.9%	190%	2.16%
AMAZON.COM INC (AMZN)	2.7%	55%	1.31%
META PLATFORMS (META)	1.3%	138%	1.18%
ALPHABET INC (GOOGL)	3.4%	36%	1.16%
TESLA INC (TSLA)	1.5%	113%	1.15%
			12.37%

Through the end of the second quarter of 2023, the S&P 500 Index has returned 16.8% year to date. As you can see in the table above, most of the return of the index (12.4%) is attributable to just seven stocks: Apple, Microsoft, Nvidia, Amazon, Alphabet, Tesla and Meta. This narrow market leadership also manifests itself in other ways:

• While the S&P 500 Index (large cap) has returned 16.8%, the S&P 400 Index (mid cap) is +8.8%, and the S&P 600 Index (small cap) is +6.0%.

• While the S&P 500, a market-capitalization-weighted index, has returned 16.8%, the S&P 500 Equal Weight Index is +7.0%.

• The largest seven companies in the S&P 500 Index now represent the highest share of market cap (25%) on record, and Apple’s market cap now is roughly the same as the entire Russell 2000 Index.

Market Dynamics

Exploring the Reasons Behind Market Concentration and Expanded P/E Multiples

A very reasonable question is why is this happening? The most logical explanation would be that the fundamental outlooks for these companies have significantly improved over the course of the year. However, when we look at how earnings expectations for each name have changed year to date, we see it’s a mixed bag.

Name	YTD Return	12/31/22 FY 2023 Earnings Estimate	6/30/23 FY 2023 Earnings Estimate	% Change	12/31/22 FY 2024 Earnings Estimate	6/22/23 FY 2024 Earnings Estimate	% Change	12/31/22 Blended Forward P/E Multiple	6/30/23 Blended Forward P/E Multiple
AAPL	50%	6.20	5.98	-4%	6.75	6.57	-3%	20x	29x
MSFT	43%	9.57	9.62	1%	11.17	11.01	-1%	23x	31x
NVDA	190%	3.26	3.26	0%	4.34	7.66	76%	34x	50x
AMZN	55%	2.17	2.55	-6%	3.99	3.54	-11%	31x	43x
META	137%	10.19	12.96	27%	12.53	15.9	27%	12x	20x
GOOGL	36%	5.85	5.74	-2%	6.86	6.78	-1%	15x	20x
TSLA	113%	5.32	3.44	-35%	6.57	4.78	-27%	23x	65x

Interestingly, near-term earnings estimates for Apple, Microsoft, Alphabet and Amazon are little changed year to date despite their huge stock price moves. Estimates are down significantly for Tesla. The only two names with significantly improved earnings outlooks are Nvidia (where full year 2024 estimates have almost doubled year to date) and Meta. So, the answer to the question of why this is happening is because price-earning (P/E) multiples are expanding. Why are multiples expanding? That’s impossible to know for sure. Common explanations are a) exposure to the artificial intelligence theme; b) “strong and predictable” growth; c) more optimism related to the macro outlook and interest rates; and d) “flock to safety” of higher-quality names with fortress balance sheets. At the end of the day, sentiment toward these names has improved, and valuations are more expensive than they were coming into the year.

The Importance of Market Breadth

Examining the Implications of Narrow Leadership and Its Impact on Market Returns

At this point you may be saying, so what!? If you own the market via index funds or exchange-traded funds and you’re up close to 17% year to date, why should you care if the leadership is narrow? It matters because in a typical bull market widespread participation (aka strong market breadth) across most stocks confirms the uptrend’s strength and its potential sustainability. When participation in the uptrend is narrow, the weight of the uptrend is reliant on a limited number of stocks. The lack of more widespread buying across equity markets also points to the perception of limited attractive investment opportunities and an overall lack of bullish conviction among market participants.

A simple way to quantify market breadth is to look at the percentage of stocks in the S&P 500 Index currently trading above their 200-day moving average. The below chart breaks the S&P 500 Index into five buckets (quintiles) based on S&P 500 Index market breadth going back to 1991. Quintile 1 represents the highest 20% of breadth readings during this time frame, while the fifth quintile represents the lowest 20% of breadth readings. The chart shows subsequent returns over various time frames following these periods of varying market breadth. As you can see, market breadth matters as it relates to future market returns: subsequent market returns are stronger when more names are participating in the current uptrend.

As of the end of the second quarter, 60% of the S&P 500 is currently trading above its 200-day moving average. So, we would be in quintile 4. Historically, this has portended weaker-than-average subsequent market returns. It is worth noting that market breadth has improved in recent weeks, as only 39% of stocks were trading above their 200-day moving average at the end of May. This is an encouraging sign.

In Conclusion

What should be done by stock market investors? Again, hard to say. It’s certainly possible that the mega-cap winners keep winning. It’s also possible that the market laggards start outperforming. It is notable that many of these lagging names are more cyclical, lower pricing power, higher interest rate-sensitive stocks that are generally more economically sensitive. Given that trees cannot grow to the sky, at a minimum, market investors should review exposures and rebalance equity allocations back to desired levels. If large-cap growth exposures have become outsized, rebalancing into underperforming smaller-cap value names may make sense.