You may have heard, watching one of the popular business networks such as CNBC, Bloomberg or Fox Business, a reporter use a term “market internals.” This is a common description of a set of statistical indicators that reflect the overall health of the stock market. Think of these indicators as being analogous to an individual’s blood pressure, pulse rate and cholesterol level. Just as with an individual’s health condition, it is important to keep a tab on these indicators because they can at times tell a different story than what the general appearance may reflect.
My comments today will focus on a particular market internal indicator that I’ve become somewhat concerned about. The indicator is market breadth. Often it is reported as a ratio of gainers-to-losers after the end of the day’s trade. For example, “Today, winners outnumbered losers 3 to 1.” A healthy overall stock market would have broad participation in terms of the number of stocks advancing and it would measure gains across all sectors. As we stand at the mid-point of 2015, market breadth is becoming increasingly concentrated in a handful of sectors and a limited group of individual stocks. The levels of concentration have yet to reach the extreme levels witnessed at the end of the Internet tech bubble in the late 1990s and early in 2000, but we are beginning to trend in that direction.
To illustrate my point I looked at the returns of the S&P 500 Index stocks over the past six months. For that period (ending July 17) the benchmark index is up 4.4% assuming dividend reinvestment. This index is based on market capitalization, meaning the largest companies by market value carry the most weight in the index. During that same timeframe, the median individual stock return for all stocks in the index has been 2.9%. However, if you strip out the performance of the top 50 stocks, the median drops to just 0.4%. The top 50 stocks have generated an average return over the past six months of 35.6%.
This bifurcation doesn’t go undiscovered forever. As it becomes more apparent which stocks are moving with high momentum more investors jump on board, accelerating the movement and intensifying the differential compared with the broader market. Eventually, the price appreciation decouples from underlying fundamentals, setting the stage for a sudden and sizeable correction. At present this group of top performing stocks trades at an average forward price-to-earnings multiple of 33.4 which is double the multiple for the S&P 500 overall.
Another way to illustrate this trend is by splitting the market into growth and value. Growth would be a subset of companies reporting earnings growth much faster than the average company in the index while value represents those companies whose stocks are trading at valuation multiples below the market average. Year-to-date growth stocks in the S&P 500 are up 7.2% while value stocks are up just 0.6%, again assuming dividend reinvestment.
Finally, when you look at the best-performing sectors you see a large spread between the top three – healthcare, consumer discretionary and technology – and the bottom three – energy, utilities and basic materials. Specifically, the difference between the healthcare sector and the energy sector over the past six months was 22.2%.
Overall, it is common for leadership in the stock market to rotate across companies and sectors as the business cycle unfolds, but periods in which the concentration of leadership begins to narrow, including just a small group of stocks in one or two sectors, you need to pay attention and invest carefully. First, you need to avoid the mistake of chasing the hot names. Second, you can’t afford to ignore the bargains that may exist in the weaker parts of the market.
While it can be very profitable in the short run to chase the momentum stocks, you must be very good at timing the exit to realize the gains, which is not as easy as it sounds. Moreover, you need to be patient when buying under-valued stocks because the recovery may not be instantaneous.
Our approach to portfolio construction allows for both growth and value stocks to exist in the portfolio but without too much concentration in either. The returns from such an approach may not keep up with the hottest performing individual stocks, but the downside risk overall is much less.
Jack E. Payne, CFA, CFP
Chief Investment Officer