No, we are not writing a piece on halitosis. “Bad Breadth,” in market lingo, refers to periods in the markets when investment performance is being dictated by a limited number of companies. In other words, it is a period when the bulk of the market is not materially participating in a market rally.
At first glance, it has been a great start to the year for the S&P 500 Index, up 15.2% through June 20, 2023, after a down year in 2022 that saw the index fall 18%. However, when you dig a little deeper, the index’s returns to date have been driven by the gains of the “Magnificent Seven,” also known as Apple, Microsoft, Alphabet, Amazon, META, Tesla, and NVIDIA. A quick refresher: the S&P 500 Index is capitalization-weighted, which means the largest company, Apple, commands the largest allocation of each dollar invested in the index. The Magnificent Seven are currently the seven largest companies – by market capitalization – in the index and represent 27.5% of the entire index. That means 27.5% of each dollar invested in the S&P 500 Index is allocated amongst only those seven names. Through June 20, 2023, the Magnificent Seven are up an average of 90%, and since these stocks are the seven largest companies in the index, their year-to-date performance has greatly impacted the performance of the entire index. I will state the obvious: The outsized gains in these companies indicate a separation from reality. The fundamentals do not support the returns and are very reminiscent of prior periods when market performance was being driven by computerized trading programs and not by the fundamentals of the specific companies and the overall economic environment.
For comparison, there is an S&P 500 Equal Weight Index, and, per its name, the 500 companies in that index are each given an equal weight in the portfolio. For example, News Corp, the smallest company in the index, is given the same allocation as Apple, the largest company in the index. Through June 20, 2023, the S&P 500 Equal Weight has underperformed the S&P 500 Index – which, remember, is capitalization-weighted – by 9.4%, the second-worst six-month relative drawdown in history. The worst six-month underperformance between the two indexes was 10.3% in August 2020, the early days of COVID and the start of the pandemic-day trading craze. Historically, these gaps in performance have reverted to the mean; over the last 15 years, the S&P 500 Index returned 10.4% annually, and the S&P 500 Equal Weight Index returned 10.3% annually. If history repeats itself, then that will mean one of three things: the Magnificent Seven will give back a portion of their gains, the rest of the S&P 500 Index will play catch-up, or a combination of the two will occur.
Last week, I attended a conference in Half Moon Bay, California, and there was a great session with speakers from Goldman Sachs, PIMCO, and Apollo Global Management. The 30-second summary: the current market is a very difficult market to forecast. The Federal Reserve is trying to slow the economy by maintaining interest rates higher for longer to reduce inflation, and since it generally takes a year or so for prior hikes to filter through the economy, we are only now feeling the impact of the aggressive interest rate hikes of last summer. That being said, there may be more surprise casualties, in addition to the banking failures we saw earlier in the year, after 15 months of rate hikes. Our take-home message: stay diversified – do not get swept up in the large-cap growth rally. The markets will eventually normalize; at present, there are still too many unknowns to feel comfortable on the outlook.
As a complete aside, on the subject of non-market halitosis – about two months ago, Karen and I started brushing our little dog Molly’s teeth on a nightly basis. We have had dogs for 30-plus years and never engaged in this before, but, wow – what a difference it makes. No more doggy breath! Now, if only we could get her to start flossing...
- Alp Atabek
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