Larry Berman

Berman's Call

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The S&P 500 hit an all-time high in early July. Less than 20 per cent of the stocks in the S&P 500 made new highs as the index broke out. Historically, 20 per cent or more is a sign of a broader market advance; technically we call this a breadth thrust. Last week, the continued push came with less than 5 per cent of stocks hitting new highs. In 2015, were it not for the impressive performance of the FANG stocks (Facebook, Amazon, Netflix, and Google), the S&P 500 would have been down about 4 per cent. Currently, the top 10 holdings in the index represent 17.96 per cent of the total weight and the top 66 stocks are 50 per cent of the index. One year ago, the top 10 stocks in the index were 16.82 per cent of the weight and the top 68 stocks were 50 per cent of the index. Two years ago it took 70 stocks to make up the top 50 per cent of the S&P 500. My point is that as the market has stagnated over the past few years, fewer stocks have been keeping the market up. The recent drop off in breadth suggests the trend is weakening and correction risk is increasing.

That said, these divergences were much worse in 2015 as small caps were very weak. Overall, the Russell 2000 small cap index has done better this year, but is still way overvalued. The trailing multiple is 43x earnings while the one year forward multiple is a more reasonable 21.8x earnings. Small caps tend to have a higher multiple than large caps due to their higher potential for growth. But the difference between trailing and forward multiples implies that earnings growth will be close to 100 per cent over the next year, which is practically INSANE!

With over 90 per cent of S&P 500 companies reported, earnings season almost over and focus will soon turn back to macro issues. According to Factset, Q3 earnings forecasts have declined 2.4 per cent since June 30 leaving lots of room for disappointment. The last leg to earnings season is typically the retailers. Given the poor showing of retail sales of late, odds are high that forward looking outlooks are reduced. The equal weight sector ETF (XRT) is still more than 10 per cent lower than its 52-week high. Companies like Amazon, Home Depot, and McDonalds that make up 25 per cent of the Consumer Discretionary Sector ETF (XLY) have done very well compared to the equal weight retailers’ ETF (XRT) where Amazon is a little more than 1 per cent of the index. The average retailer is not doing as well as the large cap weighted retailer index suggests.     

Late in the business cycle, this type of market behaviour is typical. It suggests that the broader economy is slowing, which is clear by the recent trend in US data. I’ve been defensive in portfolios for a few months and I see no reason to get excited by the market making new highs. Risk is greatest in portfolios from a market high point especially when the underlying breadth of stocks is not supportive.

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