Bad Breadth

September 27th, 2014
in contributors

Sungarden Investment Research Article of the Week

by Rob Isbitts, Sungarden Investment Research

Investors have heard about record highs in the stock market for months now. Headline indices like the S&P 500 and the Dow 30 broke their record highs this summer, and are still quite close to them. But what about the other indices? According to a recent Bloomberg article:

"About 47% of stocks in the Nasdaq Composite Index are down at least 20% from their peak in the last 12 months while more than 40% have fallen that much in the Russell 2000 Index and the Bloomberg IPO Index."

Some will refer to this as a two-tiered market. We prefer to call it "bad breadth."

Follow up:

What is breadth and what does it mean to you as an investor? Stock market breadth is simply the percent of stocks in an index moving one way or another. It is used by market technicians to get a feel for the strength of a positive or negative move in the market. For example if 60% of the stocks in the S&P 500 were moving upwards, the index is said to have positive breadth and vice versa. For a longer term picture of the overall strength of a market movement, we can look at the number of stocks hitting 52-week highs versus the number hitting 52-week lows.

So why the divergence in breadth between the major indices? First lets talk about the types of stocks that make up each index. The S&P 500 contains 500 American corporations with an average market cap of about $37 billion (in other words, very large corporations). The Dow 30 is a collection of well known companies which together are intended to broadly represent the US economy. The Nasdaq Composite index is comprised of 3000 companies and is widely considered a bellweather for growth and technology stocks. And finally, the Russell 2000. This is an index of 2000 small cap companies.

Back to our second question. It all comes down to volatility. Speculative and growth retail investors (read: investors that hold stocks from the Russell 2000 or Nasdaq Composite) tend to hold stocks that are more volatile than what many professional investors would own. However, unlike an institutional investor or a professional money manager, these small investors tend to sell at the first sign of trouble. The divergence in these indices show that speculative and growth retail investors are becoming more and more conservative with their investments. At Sungarden, it's our view that these smaller more speculative investors serve as a "canary in a coal mine" for the rest of us. We don't avoid them outright, but we tread carefully with them.

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