Scarcely a day goes by when I don’t see someone tilting at windmills trying to defend the U.S. equity market against allegations of narrowness or, more simply, bad breadth.
I’m always a bit perplexed at those breathless efforts for a couple of reasons. For one thing, everyone knows a handful of high flyers shoulder a disproportionate share of the burden when it comes to sustaining the rally. It’s not as if that’s debatable. As Goldman noted last month, through July 28 “the top 10 contributors accounted for 62% of the S&P 500’s 7% YTD return [and] of those 10 stocks, nine are technology or internet firms, [with] the Technology sector alone accounting for 56% of the S&P 500 YTD return (76% including Consumer Discretionary members AMZN and NFLX).”
It just is what it is.
Beyond this not being debatable, another reason it’s a bit strange that people spend so much time arguing with themselves about market breadth is that if you’ve been long at the index level for years, it’s not entirely clear to me why you should care one way or another what accounts for your gains. Sure, if you plan to stay long it helps if you can make a plausible argument that the rally doesn’t rest on a shaky foundation, but even there, there’s no rule that says narrowness everywhere and always precedes some kind of dramatic drawdown.
In any event, the last time I broached this subject I highlighted some commentary from Goldman in which the bank noted that one peculiar thing about narrow market breadth in its current incarnation is that it’s playing out against a backdrop of strong earnings across the board. “The top 10 S&P 500 stocks currently account for 20% of index earnings, roughly the same as in each of the last few years, and slightly below the 30-year average of 21%”, the bank wrote late last month, adding that “in 2019, consensus expects the median S&P 500 stock to grow EPS by 10%, slightly faster than the 9% growth expected for the index.”
Their explanation for the relatively anomalous combination of narrow market breadth and broad-based EPS gains was down to worries about global growth and the potential knock-on effects of the trade frictions creating jitters in sectors that might not otherwise be jittery. That’s an oversimplification, but you get the point.
This topic became even more relevant in the wake of Facebook’s disastrous Q2 earnings call, during which executives made an already dastardly after hours session worse by tipping an imminent revenue slowdown. That catalyzed a correction in the FANG+ index, which raised questions about what sector would take the baton in the event tech suddenly rolled over.
Apple’s quarter allayed some of those fears, but the FANG+ correction appeared to at least partially validate concerns expressed by the likes of Morgan Stanley’s Michael Wilson, who has variously called time on the tech rally. Incidentally, Goldman does not agree with a bearish take on tech, despite taking note of narrow market breadth.
It’s with all of that in mind that Barclays is out with an interesting new piece called “FAANGs’ big bite of Index returns: Perspective and Implications.” Spoiler alert: it’s a bit more rigorous than the analysis put forth by your favorite Twitter pundit, but it’s not all bad news – not at all in fact.
“The ‘FAANG’ stocks, (i.e. Facebook, Amazon, Apple, Netflix and Alphabet/Google), have returned nearly 80% from Jan 2017 to July 2018 while SPX gained 29.7% over the same period [and] as a result, FAANG stocks now account for more than 13% of the total S&P 500 index by market capitalization”, the bank’s Maneesh Deshpande begins.
Deshpande then notes the obvious, which is this:
Importantly, the return of the S&P 500 index over the same time would have been only 25% if the FAANG stocks were excluded. More recently the SPX 2018H1 returns are 2.6% while the ex-FAANG returns were only 0.6%.
So you know, you can slice it and dice it and roll out whatever your personal favorite measure of market breadth happens to be, but the reality of this situation is that the rally depends for its viability on FAANG. Importantly, that doesn’t mean the situation can’t change; that is, nothing says Value couldn’t suddenly come back from the dead to lead the market in the event Growth and tech get tired. Rather, it’s just to state the obvious (again).
Barclays goes on to ask the following three questions:
- From a historical perspective, how unusual is the current level of narrowness of market returns?
- What are the implications for future index returns given this market behavior?
- What are the implications for the future returns of stocks which contribute to NMR?
In order to answer these questions, Barclays builds themselves a measure of “narrowness of market returns” or, “NMR” based on original work by Cliff Asness (which is amusing). We’ll skip the mechanics of that and just cut straight to the point.
“Yes”, the market is narrow, but “no”, it’s not necessarily anomalous from a historical perspective. “The current level of NMR is currently 7.8% which is in the 87th percentile over this period”, Deshpande writes, describing the visual below and noting that “while this is elevated there clearly have been past episodes where it has been close to this level.”
So what does this mean for the broader market going forward? After all, this entire debate is ostensibly about whether bad breadth leads to poor returns. At the index level, Barclays notes that “high levels of NMR are a headwind for subsequent 12 month market returns”, but the good news is, “the correlation is not very high.”
As far as what you can expect from the stocks that contribute to market narrowness, Barclays notes that there’s a difference between those names and pure momentum names and distinguishing between the two is key to predicting subsequent out/underperformance.
“One of the major concerns for investors is whether these top performing stocks, e.g. FAANGs will bear higher selloff risks should external catalysts such as political, regulation or macroeconomic risks trigger strong rotations”, the bank writes, before delivering the following breakdown of NMR stocks versus pure momentum stocks in terms of 1-month, 6-month and 12-month returns:
Basically, NMR stocks do marginally underperform, but momentum continues to exhibit, well, momentum. “To sum up, the perception that these NMR names are merely momentum stocks is questionable”, the bank says.
But see, therein lies the problem with the current market structure. Thanks to passive investing and the dynamics created by the proliferation of smart-beta products, it’s becoming more and more difficult to distinguish between momentum, growth, tech, low vol., and various other factors used to create non-index passive products.
Just ask Howard Marks, he’ll be happy to tell you all about that.