Hard to Concentrate: Top-Heavy Market

Imagine two strategists having stood on the proverbial debate stage at the start of this year. One proclaimed that stocks would rip higher in the first half. The other proclaimed that stocks would have a significant correction. Both would have been right. It's been a tale of two markets this year—one at the index level and one under the surface. As shown below, none of the major averages have had even a 10% correction at the index level; with maximum drawdowns limited to only -5% for the S&P 500, -7% for the Nasdaq, and -9% for the Russell 2000. But at the average member level, the maximum drawdown within the S&P 500 has been -15%, while it's a whopping -38% for the Nasdaq and -29% for the Russell 2000.

The large-cap size bias in performance can also be illustrated via the chart below, showing that the size factor is at a near-record high three-month correlation to the S&P 100 index, which is itself representative of the largest stocks in the overall S&P 500. The large stock bias is also the case within smaller cap indexes.

The dramatic outperformance of a small handful of stocks at the very upper end of the market capitalization spectrum has greatly flattered index-level performance among cap-weighted indexes. On the other hand, there has been a tremendous amount of churn and rotational corrections occurring under the surface. Cap-weighted indexes having performance biased by a small number of mega-cap stocks is not historically abnormal; but when the "rest" of the market is sorely behind, concentration risk becomes more acute. As shown below, only 17% of the S&P 500's members have outperformed the index itself over the past year; although the percentages are better for shorter periods, there is no period within six months having more than 26% of stocks outperforming the index. It's even more extreme within the Nasdaq; with only 11% of its members having outperformed the index over the past year and the largest percentage over the past six months is only 18% (over the past three and four months).

Another way to express this concentration phenomenon is by comparing the index change with the change in the cumulative advance-decline data. Shown below, for both the S&P 500 and Nasdaq, the indexes have been powering higher, but that's alongside deteriorating breadth as measured by the number of advancing vs. declining stocks within each index on a cumulative basis.

Per always-insightful analysis by our friends at Bespoke Investment Group (BIG), there have not been many examples of this amount of divergence in breadth and price since the turn of this century. However—and this will probably shock no one—the 1990s had similar divergences on multiple occasions. In fact, the occurrences throughout the 1990s were actually characterized by far weaker breadth than what we've seen recently. The history lesson from the 1990s experiences suggests some possible near-term consolidation in terms of index performance, but still-strong performance looking ahead beyond six months.

In terms of possible consolidation near-term, the S&P 500 has gone nearly 18 months without a 2% daily decline. There have been periods in history with longer stretches of calm—including the longest ever between 2003 and 2007 and quite a few between the mid-1960s and mid-1980s. Still, by the time the streak reached this many days, the index in general started to sputter a bit (hat tip to our friends at SentimenTrader). All but two of the historical streaks at least as long as the latest saw the S&P 500 generally trade lower two or three months later. The exceptions were the "remarkable creeper trend" of 1995 and again in 2004 (during the aforementioned-longest streak in history).

As a result of the remarkable concentration of performance up the cap spectrum, the 10 largest stocks as a percentage of the S&P 500's overall market cap have surged to 38%, as shown below.

There is often conflation of the largest stocks with the best-performing stocks. They are not one and the same. In fact, for all the focus on the so-called Magnificent 7 or the Fab5, among them, only Nvidia is on the top-10 list of year-to-date performers within the S&P 500. You might also be surprised that Nvidia is not the best-performing stock this year…that award (for now) goes to Super Micro Computer with its performance besting Nvidia's to the tune of more than 60 percentage points. As shown below, it also may surprise some that three of the top-10 best performers this year are not in the Technology sector, but instead in the Utilities sector. Credit the second-order beneficiaries of the artificial intelligence (AI) boom, as well as the build-out of the country's energy grid. The list has also gone "old school" with General Electric…go figure!

Looking ahead, we think a risk worth monitoring is the persistence of the aforementioned divergence between performance at the individual member and index levels. If we continue to see more weakness in the former and strength in the latter, it will start to eerily mimic 2021's dynamic. As shown below, as the S&P 500 has made several new highs this year, there has been a breakdown in the percentage of members trading above their 50-day moving average. That was the case in the second half of 2021 which, with the benefit of hindsight, correctly signaled that the market would no longer be able to hold up at the index level—thus leading to the bear market in 2022.

A similar divergence has occurred within the Nasdaq 100, but as shown in the chart below, the index has had a stronger rebound lately in the percentage of members trading above their 50-day moving average. That likely speaks to the fact that in the post-pandemic world, investors have tended to jump into "big tech" when skittishness has crept in. Large-cap growth segments of the market have increasingly been treated as a form of defense.

Even with that rebound, though, strength in performance remains concentrated in a handful of industries and names. As shown below, despite the fact that large-cap indexes like the S&P 500 and Nasdaq 100 have made several new all-time highs this year, that has not been the case at the individual member level. As of last Friday's close, fewer than 10% of members in both indexes were at new 52-week highs, with a steady deterioration over the past few months.

Of course, it's not realistic to see every member at a new high at any one point, even in powerful bull markets. In fact, looking back to 2021, even as the indexes were soaring, there was never a day when more than half of members in the S&P 500 were at a new 52-week high; that kind of strength tends to happen in phases.

Given that, it's useful to also look at how many index members are falling to new lows—not just failing to make new highs. Shown below, as the year has progressed, there has been a steady climb in the percentage of stocks in the S&P 500 and Nasdaq 100 in their own bear markets (defined as being at least 20% below their 52-week high). They're not back to worrisome percentages seen during last year's correction, but the bar is arguably higher this time since the indexes have gone on to make new highs this year.

This year's tale of two markets has been to the benefit of passive investors who are mostly focused on index-level returns. Major indexes have not experienced a correction, but under the surface, there have been declines of bear market magnitude. Of course, if there's a "good" way to go through a correction or a bear market, this year has probably been the epitome of that. However, we do see building risks of some consolidation at the index level if performance divergences persist into the second half of the year. While they don't seem imminently fatal to the bull market, we think more members will need to start joining the party for the music to stay on.