Three days ago, just before the biggest market drop in weeks, we wrote an article attempting to answer "when does the market breakdown again" where we said the answer is in the advance-decline line....
... for one reason: the absolute collapse in market breadth had become the biggest threat to the rally since late September.
BofA noted that "the rise in the US Dollar has had a bearish impact on global equity market breadth (many equity markets have done much better in local currencies) and this A-D line has not confirmed the global equity market rally. This is a major bearish breadth divergence and a classic sign of diminishing breadth for global equity market indices."
We added that what this "means that the central banks, whose only mandate is to keep the global market from crashing, is they will have to buy - either directly like the SNB and BOJ or indirectly/spoof like the NY Fed via Citadel - much more than just the E-mini and a handful of stocks to give the impression that the market is healthy when in fact, it is not."
For now they are failing.
Which explains why suddenly the topic of collapsing market breadth is the biggest concern among Goldman's clients.
As Goldman's David Kostin explains, narrow market breadth has been a recent topic of investor discussions.
Clients are quick to point out similarities between the current low breadth environment and the narrow breadth regime that emerged during the tech bubble in the late 1990s. A narrow market exists when a few stocks drive the majority of the index-level return. Five firms – AMZN, GOOGL, MSFT, FB, and GE – totaling 9% of the equity cap of the index have accounted for more than 100% of the S&P 500 YTD return. Stated alternatively, without these stocks the index would have posted a 220 bp lower total return or -2.2% YTD.
We introduce the Goldman Sachs Breadth Index (GSBI) to track market breadth (see Exhibit 1). The index utilizes S&P 500 constituent weights and 6-month returns to assign a market breadth value between 0 and 100. Readings below 5 indicate that market breadth is especially narrow.
Our Breadth index currently equals 1, one of the lowest levels in the 30- year series. The Breadth index has stayed below 5 for at least two consecutive months just 11 times since 1985 (Exhibit 1). The typical episode lasted four months, with past episodes ranging from two months in 2007 to a high of 14 months during the tech bubble. The current exceptionally narrow breadth period is just one month old but is on track for a second month, so this environment could reasonably be expected to persist into early 2016.
Factor analysis shows that high quality stocks tend to outperform in narrow breadth environments, although results were inconsistent. Using our long/short Micro Equity Factors (MEFs), we can evaluate the types of stocks that typically outperform in narrow breadth environments. Firms with strong balance sheets outperformed firms with weak balance sheets in 7 of 11 narrow breadth periods. Low volatility stocks also outperformed their higher volatility counterparts in 7 of 11 episodes. In contrast, the “lower quality” Russell 2000 index outperformed the S&P 500 during 8 of the 11 periods, the best factor hit rate (see Exhibit 3).
The subsequent performance of stocks in a narrow breadth market has been mixed. Factor analysis shows that high momentum stocks outperformed low momentum stocks in 64% of narrow breadth episodes. During the six months leading into the 1994 low breadth episode, the top ten contributing stocks accounted for nearly 90% of the S&P 500 return. However, during the six months following the initial low breadth index reading, the median stock in the list fell by 4% while the S&P 500 returned 3% during the same period. The 1999 episode was a different story: The top 10 contributing stocks accounted for nearly 900% of the S&P 500 return ahead of the first low reading of our breadth index. The median stock surged by 62% during the subsequent six months and accounted for 51% of the index return and pushed the overall S&P 500 index up by 18% during that period.
In other words, BTFD is nothing new.
But is breadth a relevant indicator? That depends: just like there has not been a major market crash without a Hindenburg Omen, so market breadth has collapsed before every single prior recession. However, just like the H-Omen, breadth has had numerous false negatives, and 8 very narrow breadth periods ended without an economic contraction. To wit:
On its own, narrow breadth is an unreliable indicator of a recession or market peak. Breadth was extremely narrow preceding each of the three recessions during the last 30 years, but the remaining eight narrow breadth periods ended in relatively healthy growth environments. While breadth was especially narrow before the market collapses of 2000 and 2007, the S&P 500 exited 7 of the 11 narrow breadth episodes in a positive fashion, with the median episode producing 6- and 12-month returns of 3% and 9%. In short, narrow breadth by itself does not appear to be a cause for investor concern.
And while Goldman is eager to spin the bullish case, its clients are no longer as believing:
On the other hand, clients continue to point to similarities between the current narrow breadth environment and that of the later years of the tech bubble. S&P 500 forward P/E currently equals 16.3x, near the highest level since the tech bubble. Mega-cap growth stocks explain a vast majority of the trailing 6- and 12-month S&P 500 return. Other similarities to the late 1990s provide a persuasive case for why mega cap outperformance will likely persist, at least in the near term. Modest US economic growth and peak margins should put a premium on stocks with perceived high secular growth prospects.
Or, said otherwise, Goldman's clients are nervous because with just 5 stocks (!) propping up the entire market, the party is to end with a bang (especially for the small and mid-cap momos). And, as the action on Friday confirmed, the "market" is finally getting the memo.