Bad Breadth – why narrow market leadership argues against a new bull market

Andrew Mitchell

Ophir Asset Management

What worries?

We all thought share markets had a list of worries as far as the eye can see from inflation, interest rates, banking crises, debt ceiling worries and slowing growth.

But this year they casually shrugged off those fears and anxieties and generally headed higher. The MSCI World index (in USD) is now up over +8% and the S&P500 up +9.2% this year to the end of April.

Investors only gazing at the sunny headline results for those key indices I just mentioned might surmise that markets have packed up all their troubles in their ‘old kit bag’ and are smiling all the way to a new bull market.

But all is not what meets the eye. Unfortunately, like an iceberg, there is way more going on below the surface. Despite major share market indices rising strongly this year, many stocks remain underwater (down on the year). The current market could lure investors, unaware of the dangers lurking, into a false sense of safety and optimism.

Currently size is the big winner in the world’s largest share market, the U.S. That is, the biggest companies have dramatically outperformed smaller companies. JP Morgan said by some measures this is the narrowest market leadership in a rising market since the 1990s, which has implications for the longevity of this rally.

Howard Marks once said, "the concentration of gains in a small number of stocks is a warning sign that the market is becoming too dependent on a handful of companies and that it may be vulnerable to a sharp decline if one or more of those companies stumble."

This performance divergence by size began in early March when Silicon Valley Bank collapsed. Markets dramatically repriced the number of interest rate hikes left this cycle by the Fed. U.S. Micro, small and mid-caps sat out the rebound over late March and April. But the key indices that most investors follow are market-cap weighted and they are therefore influenced most heavily by the biggest businesses in the world.

So, investors could be forgiven for missing that most stocks have actually not participated in this rally.

Looking under the surface further, below we break down U.S. share market returns for the four months to the end of April by both size and style.

What you can see is that:

  1. Large caps are the standout winner.
  2. Growth has been the best style for large caps, but the worst for small caps.

Liquidity from investors has clearly gone to the biggest and most growth-orientated companies in the world for several reasons:

  1. A flight to safety on the back of the U.S. regional banking issues.
  2. Lower long-term bond yields increasing valuations for mega-cap tech companies, reversing some of the valuation compression from the second half of 2022 as a result of higher rates.
  3. Increased optimism around generative artificial intelligence (AI) and Large Language Models (LLMs) that many investors expect a number of mega-cap tech companies to benefit from.

But even within U.S. large caps (as measured by the S&P500 index), returns have been driven by a small sliver of gigantic-sized companies.

Below, we show the top 10 contributors to the S&P500’s 9.2% total return this year. The top 10 have driven 7.4% of that 9.2% return (80%), even though they make up only 27% of the index by weight. Those top 10, mostly household names, are up on average 41% this year, whilst the other 490 members of the S&P500 are up on average a paltry 2.5%.

Why does all this matter?

With share markets like the U.S., Europe and Australia having risen from their lows in the second half of 2022, many are asking: has a new bull market for shares started?

A major problem is that, based on history, this rally should be broader if we are to be confident this is the start of a new bull market.

As I highlighted above, this recent rally in U.S. large caps (S&P 500) has been accompanied by dramatic underperformance in U.S. small caps.

During bear markets (greater than 20% falls in the S&P500 index), whether accompanied by a recession or not, you tend to see small caps underperform going into the market fall… but then small caps outperform in the recovery, which kicks off the new bull market.

The strong share market returns we have seen so far in 2023 from global equities have been narrowly driven, which is not what tends to happen at the start of new bull markets.

We would expect a greater number of companies, including small caps, to have participated to be more confident that the recent market rally will continue.

That does not mean this still couldn’t occur, but the evidence is not there yet.

This is one of the reasons we haven’t been chasing the market rally this year.

Disclaimer: While all reasonable care has been taken in the preparation of this information, Ophir Asset Management take no responsibility for any actions taken based on information contained herein or for any errors or omissions. Interested parties should seek independent advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.

Andrew Mitchell
Director and Portfolio Manager
Ophir Asset Management

Andrew has over 15 years’ experience in portfolio management of listed companies, stockbroking and economic analysis. Prior to co-founding Ophir, Andrew worked from 2007 to 2011 as a portfolio manager at Paradice Investment Management.

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