By The market’s case of bad breadth is finally showing signs of improvement, but it still operates in a megacap-dominated world. In the past three weeks, we’ve witnessed a remarkable turnaround for stocks further down the market-cap spectrum. The equal-weighted S&P 500 has outperformed its market capitalization-weighted counterpart by three percentage points, resulting in a 6% surge. However, despite this positive development, its year-to-date gain of nearly 8% is only half of what the regular S&P 500 has achieved.
This stark difference in performance is a significant departure from the first half of the year when regional banking instabilities, the AI investing frenzy, and concerns surrounding contentious debt-ceiling negotiations in Washington limited investors’ choices to a narrow group of megacap technology companies. During this period, the performance of these seven largest U.S. stocks, including Apple (ticker: AAPL) and Nvidia (NVDA), far exceeded the rest of the market, driving the S&P 500 higher while leaving most other index stocks relatively unaffected.
However, a market heavily reliant on a handful of stocks cannot sustain such a trend indefinitely. This realization, coupled with changing sentiment, has contributed to a more positive performance among a broader range of stocks. Recent data concerning the U.S. economy has been encouraging, particularly for smaller companies that are believed to be more sensitive to domestic economic fluctuations. As regional banking concerns ease, small-cap stocks are benefiting. Notably, banks have a more significant representation in the small-cap S&P 600 index compared to the large-cap S&P 500 index, and the pressure on this sector seems to have subsided.
Ed Clissold, Chief U.S. Strategist at Ned Davis Research, highlights this shifting landscape: “As the regional banking crisis fades, the better-than-expected economic news is once again becoming a tailwind for small-caps.” He points out that the earnings yield of the S&P 600, which is the inverse of its price/earnings ratio, is approaching a record low compared to the S&P 500. This indicates that smaller companies may present an attractive investment opportunity in light of their potential for growth and resilience in the face of economic headwinds.
The Rally Extends to Meme Stocks
The recent market rally has even found its way into the riskiest and most sentiment-driven area: meme stocks. These stocks are often associated with companies that have weak fundamentals and high short interest. Carvana (CVNA) has seen a 29% increase in just one week, while Coinbase Global (COIN) has soared by 33%. The Roundhill MEME exchange-traded fund (MEME) has also experienced a significant gain of 13%. In comparison, the Consumer Staples Select Sector SPDR ETF (XLP), which includes established names like Procter & Gamble (PG), PepsiCo (PEP), and Costco Wholesale (COST), has only seen a gain of less than 1%.
However, past periods of such dramatic outperformance by meme stocks compared to consumer staples have been followed by declines in the S&P 500. According to Jonathan Krinsky, chief market technician at BTIG, this phenomenon indicates a potential reversal in the market.
While it is encouraging to see a broader breadth of performance, Krinsky cautions against placing too much optimism in lower-quality stocks. A surge of this magnitude, particularly relative to defensive stocks like consumer staples, often signifies a chase for assets that haven’t moved much but have the potential for significant movement. In other words, it may indicate the tail end of the current rally.
There are a couple of factors that could potentially narrow the market breadth again. A stumble in the economy or a reacceleration of inflation could increase the probability of further tightening by the Federal Reserve. If concerns about a recession intensify, investors may seek refuge in mega-cap tech stocks and other stable businesses. As Steve Clissold notes, policy and economic risks are keeping the tactical rotation out of large-caps on a tight leash.
We are yet to see how short this trend will last.
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