Another month in the books and once again stocks post more gains. October came to a close with the S&P 500 rising by 2.3%, making it six consecutive months of positive returns. Not to be outdone, non-US stocks continued to outperform US stocks this year as the MSCI Emerging Markets Index rose 3.6% in October, generating positive returns every month this year and up a stellar 33.5% year-to-date (YTD).
Although major equity indices have been making new all-time highs, more recently several measures of breadth or market participation have been exhibiting worrisome signs. For example, in October, only one sector (Technology) out of eleven outperformed the S&P 500. That’s it, just one sector. Talk about narrow market leadership!
In addition, as shown in the following chart, at the end of last month, the S&P 500 experienced its worst breadth since 1990.
On October 28th, the S&P 500 finished positive for the day, but the breadth was atrocious as 104 stocks in the Index were up but 396 stocks finished the day lower. In other words, the S&P 500 Index enjoyed a positive trading day, however nearly 80% of the names in the Index finished the day lower. Just about 20% of index members were responsible for the gains – a level of weak market participation not seen in decades.
Another way to represent breadth is shown in this next chart:
The blue line is the S&P 500 and the gold vertical bars reflect the percentage of NYSE stocks that are trading above their 50-day moving average (MA). Healthy bull markets typically have a majority of stocks trading above key moving averages, indicating most stocks are in uptrends. As depicted in the above chart, whereas the percentage of NYSE stocks above their 50-day MA was well north of 70% during much of the summer months, that percentage has gradually been declining as currently just 40% of NYSE stocks are above their 50-day MA. Such a bearish divergence paints a picture of fewer stocks participating as equity indices climb to new heights. When market breadth narrows to this degree, the underpinnings of the bull market are arguably on shaky ground.
In addition to weak breadth, another area of concern involves the stocks faring the best during this prolonged market rally.
The chart above considers stocks in the small-cap Russell 2000 Index. The green line represents those member companies in the Index that have negative earnings (unprofitable) and the blue line represents those member companies that have positive earnings. Since the market low in early April, these two lines were tracking closely, but starting in July the return for negative earners has pulled away from the positive earners.
And this is not just a small-cap phenomena. Negative-earners in the large-cap Russell 1000 Index returned an average of 47% since the early April market low, compared to just a 29% average return for the positive earners.
When stocks of unprofitable companies are trouncing the returns of profitable companies, it tends to signify that investor sentiment is extremely optimistic and even complacent. By purchasing the shares of companies with negative earnings, investors are taking a leap of faith that profitability will come in due time. Yet, all too often, this hope can be misplaced. As equity indices hit new highs, investors can get caught up in the euphoria of the moment and toss caution to the wind. As we’ve discussed in past letters, investor sentiment is a contrary indicator, meaning it’s generally best to take the opposite stance. If the majority are extremely bullish, history has shown that it’s best to remain prudent and wary during such times.
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The entire team at Measured Wealth wishes to thank you for entrusting us to deliver on your financial goals.
Edward Miller, CFA, CMT
Chief Investment Officer
Measured Wealth Private Client Group
Important Disclosures
Historical data is not a guarantee that any of the events described will occur or that any strategy will be successful. Past performance is not indicative of future results.Returns citied above are from various sources including Factset, Bloomberg, Russell Associates, S&P Dow Jones, MSCI Inc., The St. Louis Federal Reserve and Y-Charts, Inc. The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. Investing involves risks, including possible loss of principal. Please consider the investment objectives, risks, charges, and expenses of any security carefully before investing.
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