Market Breadth Improvement : Bull Market Health and Sustainability

Market Breadth Improvement: Bull Market Health and Sustainability 

Last Friday  a few "Mega-Capitalization" stocks have heavily influenced market returns, fueling the bull market. In that discussion, we questioned whether a small group of stocks could continue to sustain this trend. Additionally, the breadth of the market rally has been a significant concern. We explored this issue extensively in our piece, "Bad Breadth Keeps Getting Worse."

"While the market reaches new highs driven by momentum, its breadth is narrowing. The number of stocks trading above their 50-DMA is decreasing. Moreover, the NYSE Advance-Decline line and the RSI have both reversed, highlighting negative divergences despite a rising market. This does not necessarily indicate an imminent market crash, but it does suggest that the current rally is weaker than it appears."

Since the start of this year, the problem of "bad breadth" has been troubling for the bull market rally. Historically, periods with narrow market advances often precede short-term corrections and bear markets. As Bob Farrell once said:

"Markets are strongest when broad, and weakest when narrow."

However, with the Federal Reserve set to cut rates for the first time since 2020, there seems to be a shift. Following the latest CPI report, there was a noticeable rotation from former market leaders to laggards. Importantly, market breadth has significantly improved, with the NYSE Advance-Decline reaching all-time highs. Additionally, previous negative divergences in the RSI and the number of stocks above their 50-DMA have reversed upwards.

What does this imply?

"Recent market actions are encouraging and could signal a maturing bull market, with a broader range of stocks contributing to the rally, offering more support for indexes at record levels." – Yahoo Finance

Historically, better market breadth indicates a healthier bull market. However, while breadth has improved, and bulls are optimistic about potential Fed rate cuts, is this broadening trend sustainable? It might be. As noted by Sentiment Trader:

"After over a month of significant divergences between indexes and individual stocks, these were largely resolved last week in a historic shift. Although a new high in cumulative breadth is a positive long-term sign, short-term returns were less certain when the S&P 500 outpaced market-wide breadth."

We concur that there are risks to the current rally in small-cap stocks.

Risks to the Russell 2000 With the Fed cutting rates and the potential for a pro-growth, tax-cutting, and tariff-friendly President, it is not surprising to see narratives suggesting that the market rally will broaden, with small and mid-cap companies taking the lead.

However, many issues still trouble these companies. As noted in our recent Bull Bear Report:

Nearly 40% of the Russell 2000 is unprofitable.

"However, several issues also affect smaller capitalization companies. As Goldman Sachs pointed out, fundamentally:

"I'm surprised how easy it is to find someone eager to call the top in tech and shift to small caps. Aside from the possibility of short-term pain trades, I don't see the fundamental case for the sustained outperformance of an index where 1-in-3 companies will be unprofitable this year."

In the 1990s, 15% of companies in the Russell 2000 had negative 12-month trailing EPS. Today, that figure is 40%."

Retail investors are chasing a rising number of unprofitable companies. These companies are heavily leveraged and reliant on debt to stay afloat (often referred to as zombies). They are vulnerable to changes in the economy.

With a slowing economy, these companies depend heavily on consumer spending to generate revenue. As consumption decreases, so does their profitability, affecting share performance. Simon White of Bloomberg emphasized this last week:

"The yield curve based on inflation expectations has flattened significantly and is now more inverted than ever. This 'expectations curve' suggests consumers anticipate much tighter financial conditions than the market infers via the nominal yield curve, posing a risk to consumption, broader economic growth, and equity valuations and returns."

Moreover, companies in the Russell 2000 lack the financial capacity to execute large-scale buybacks to support asset prices and offset slowing earnings growth. Since 2000, corporations have been the primary net buyers of equities, leading to significant outperformance by large-cap stocks over time.

While the rally's breadth has improved, these challenges may significantly impact the bull market's sustainability.

Breadth Has Improved, But Is It Enough? For a market rally to be sustainable, it needs buyers.

If the current rotation was happening from a deeply oversold condition after a broader market correction, I would be more confident in its sustainability. However, as we have previously noted, both retail and professional investors are extremely bullish.

Additionally, with such bullish sentiment, investors are fully allocated to equities. Historically, readings above 80 are associated with near-market peaks. The current reading is 87, indicating a high level of optimism.

Given these aggressive equity allocation levels and low cash reserves, the capacity to take on more exposure to push the market higher is questionable.

Finally, despite the bullish sentiment, early signs of stress are emerging in the credit market. Historically, widening credit spreads have preceded increased market volatility. As shown, the yield spread on junk bonds is rising again. While early, such increases between CCC-rated and B-rated corporate bonds have been an early warning sign of market stress.

Yes, the market could continue to shift from large-cap to small and mid-cap companies. However, considering the current high levels of bullish sentiment and allocations against a backdrop of weakening economic data and widening spreads, the current rotation might just be a significant short-covering rally. Additionally, the current technical overbought and extended conditions suggest that sustainability remains uncertain.

With investors already heavily invested in equities, the question is: "Who is left to buy?"

Furthermore, there is a risk of a broader market correction leading up to the election, which could impact both large and small-cap companies.

As Yahoo suggests, could this be the start of the real bull market?

Of course, markets can always surprise us. If the rotation continues and the economic backdrop improves significantly, supporting earnings growth, we will adjust our portfolios accordingly.

It is possible.

However, we will remain cautious in our portfolio management until the market provides convincing evidence otherwise