Market Breadth Showing a Positive Sign for Stocks
The US equity markets continued their positive trend this week with the S&P 500 posting a gain of 2.23% for the week through Thursday’s market close. The Financial Sector led the way up 7.98% followed by energy stocks, displaying a gain of 7.40%. Healthcare was the worst performing sector during this period, down 1.40%.
We are always looking for indicators to help provide some direction on investor sentiment and the health of the equity market. Over the last few weeks, we have been keeping an eye on the number of stocks that are driving returns in the S&P 500. If only a few of the big stocks are driving the returns, that is not a great sign. However, if the gains are coming from many stocks in many sectors, that is seen as a better sign. We call this looking at market breadth.
One way for us to find out if only a few big stocks are driving the returns is to compare the S&P 500 Index to the S&P 500 Equal Weight Index and the S&P 500 Top 50 Index. The S&P 500 is a market capitalization index, and therefore bigger companies get a larger weight, which means a few of the biggest companies influence the direction of the index more than smaller companies that get smaller weights. On the other hand, the S&P 500 Equal Weight Index gives each stock the same weight, and therefore neutralizes the influence big companies have on the regular S&P 500 Index. While the S&P 500 Top 50 Index is comprised of the 50 biggest companies in the original S&P 500 and is a great proxy for how a few of the biggest companies are doing.
The chart below illustrates how all three indexes are performing since the March 23, 2020 low. We can see starting mid-May, the S&P 500 Equal Weight Index (green line) is moving higher than the S&P 500 Index (purple line). This is a positive sign because it shows many companies are participating in the rally. Another good indicator is that the S&P 500 is now outperforming the S&P 500 Top 50 Index (red line) since mid-May.
Market sentiment has been driving equity returns over the last few months, and therefore has become more important to investors than the traditional valuation metrics like the forward price-to-earnings ratio. We watch both very closely because market sentiment tends to drive shorter term market movement, while the price-to-earnings ratio drives longer term returns. What all this means to us, is that as long as we continue to see this type of positive breadth in the market, it is possible for the positive momentum to continue.