Recently, an unusual phenomenon has emerged in the U.Sstock marketWhile major stock indices remain near historical highs, the market breadth is at its worst levels everThis divergence has raised significant concerns among investors and analysts alikeSome believe that market breadth, as a price signal, may no longer hold the same relevance it once didHowever, Morgan Stanley has warned that ignoring breadth is typically a "bad idea," and that this anomaly could be a warning sign for potential market risks.
In a recent report, Michael Wilson, Morgan Stanley's chief U.Sequity strategist, pointed out that the market breadth deterioration observed in early December serves as a signal of a broader issueSpecifically, it suggests that the Federal Reserve may not be able to provide as much monetary easing as the market had anticipatedWilson argues that this divergence in breadth is indicative of a mismatch between investor expectations and reality, especially in light of the Fed's current stance on interest rates.
The primary focus for investors has shifted toward price momentum, while the traditional metric of market breadth has been largely overlooked
This is partly due to a lack of mean reversion in recent years, which has caused investors to pay less attention to market rebalancingAs a result, we are seeing extreme concentration in markets, including the U.Sstock market, where a small number of large-cap stocks are driving performance, and market breadth has been significantly weakened.
Morgan Stanley attributes this increased focus on price momentum to the rise of passive investment strategies and the popularity of low-cost index fundsThese funds, which track indices like the S&P 500, often concentrate capital in a few large companies, which are the biggest constituents of these indicesThis trend has led to a widening gap between the performance of the broader index and the percentage of stocks within that index that are above their respective 200-day moving averagesIn essence, the index itself is performing well, but the underlying breadth of the market is showing significant signs of deterioration.
When it comes to the relationship between stock prices and breadth, Morgan Stanley's analysis reveals an interesting pattern
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Over the past 25 years, the gap between the S&P 500 index and the breadth indicator has typically moved in syncHowever, there have been two distinct periods in which the S&P 500 index was "high" relative to this breadth indicator: in 1999 and from April 2023 onwards.
Both of these periods share common characteristics beyond the aforementioned drivers of concentration and momentumNotably, both were marked by an abundance of liquidity provided by the Federal Reserve and/or the U.STreasuryIn 1999, the Fed maintained an accommodative stance to mitigate risks surrounding the Y2K transitionAs the year turned, however, liquidity began to tighten, which caused the gap between the index and breadth to shrink rapidly.
Fast forward to today, and the current anomaly mirrors the 1999 experience in some waysThe trigger for this period of divergence has been the massive surge in the reverse repo program (RRP), which reached a peak of $2.5 trillion
Later, in response to the regional banking crisis, the Fed injected $500 billion in reserve funds, which further altered the supply and demand dynamics in the marketThese liquidity injections have disrupted traditional market flows, creating turbulence in the broader financial system.
The current question on investors' minds is whether this liquidity-driven anomaly will persist into the futureIf the RRP scale returns to zero and the Fed’s rate cuts fall short of expectations, liquidity could tighten early next year, narrowing this gapConversely, if the Fed surprises markets with larger-than-expected rate cuts or ends its quantitative tightening program, liquidity might remain abundant, potentially allowing the anomaly to persist.
Morgan Stanley acknowledges that predicting the future course of liquidity is challengingHowever, they suggest that as liquidity begins to contract, the widening divergence between price and breadth may normalize
This means that, for some high-quality indices, breadth may become less of a concern than it has been in the pastFor example, stocks within indices like the S&P 500, which are dominated by large-cap technology companies, could continue to perform well, even if the broader market shows signs of weakness.
A deeper dive into recent market movements reveals the stark impact of this divergenceStocks with high valuations, particularly growth stocks, and those from sectors with weaker fundamentals, such as cyclical industries, have become the "epicenter" of market volatilityThese stocks, which had benefitted from the liquidity surge and the low-interest-rate environment of recent years, are now under significant pressure as higher rates and a tightening liquidity environment take hold.
As the liquidity tide recedes, these stocks, which were once buoyed by easy money, are now facing the dual pressures of a prolonged high-interest-rate environment and diminishing liquidity
For instance, growth stocks, which often rely on low rates to justify their high valuations, are particularly vulnerableSimilarly, cyclical stocks, which are sensitive to economic cycles and often struggle in an environment of slowing demand and higher borrowing costs, are also underperforming.
The situation is particularly precarious for these stocks as the reverse repo mechanism slowly winds down, draining liquidity from the system like sand through an hourglassIn a market environment where liquidity is scarce, these stocks seem particularly exposed to market shocksThe risk for investors is clear: if they do not carefully manage their exposure to these volatile stocks, they could be left holding assets that are rapidly losing value as the market adjusts to the new macroeconomic reality.
For investors looking to navigate this uncertain landscape, managing risk is paramount
Just as a sailor must adjust the sails to navigate through rough seas, investors must be vigilant in steering their portfolios through these turbulent timesThis means being cautious with high-growth, high-valuation stocks and paying close attention to the broader market signals, such as breadth and liquidity, which might indicate where the market is headed next.
One key takeaway from this current market dynamic is that while price momentum can drive short-term gains, it is important not to disregard the broader signals that the market is sendingMarket breadth, which has traditionally been an important indicator of overall market health, may not have the same prominence it once didHowever, ignoring it entirely could be a risky strategy, especially in times of high volatility and shifting liquidity conditions.
As investors look ahead to 2024, they must carefully consider how changes in liquidity and interest rates will shape the market