Early in my career, there was a running technical joke within the investment team. Whenever the stock market went through a period of “bad breadth” (more stock decliners than advancers, more new lows vs. new highs, performance gaps, etc.) and someone made mention of it in a meeting, one of us would immediately say “halitosis” (a play on bad breath vs. bad breadth) — it was a pretty silly joke indeed.
I must admit, given my focus on fundamental analysis, I am not much of a market technician. That said, some of the signals from technical observations can translate through to the fundamental factors that I continuously review. Paying attention to the moves in the market and observing all factors — even technical — can help us better understand what is happening.
Fast forward to today, where the major stock market indexes seemingly reach new record highs on a daily basis. One stunning statistic is that the S&P 500 Index has made a new high at least 50 times so far in 2021. On the surface, all appears to be well in the stock market — if large-cap index levels were the only indicator being tracked by an investor.
However, under the surface, the markets appear to have once again developed a strong case of halitosis. The breadth of underlying stocks across the broader stock market has been poor, including most sectors outside of technology. Many technical indicators and relative performance measures are displaying this pricing and performance divergence.
For example, at one point in August while the S&P 500 Index was reaching another new high, the average stock in the S&P Composite 1500 Index was down over 15% from its 52-week high, and the average energy stock was 30% below its peak. Other technical and performance indicators support this stunning disparity, but none more clearly than this week’s chart, which compares the Russell 2000 Index to the S&P 500 Index (lower values in the chart represent small-cap weakness vs. large-cap strength).
As you can see, large-cap stocks have once again exhibited their dominance over the rest of the market during the past six months. According to Bloomberg data, this performance gap resulted in a 20-year-low forward price-to-earnings ratio for the S&P SmallCap 600 Index relative to the large-cap S&P 500 Index. Performance gaps such as this are interesting to observe. But more importantly, we must understand why these gaps are occurring so we can attempt to add value in any market environment. A key takeaway is that even when the stock market is reaching new highs, there could be some value found beneath the surface in underfollowed small-cap stocks and other areas of the market.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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