When the Troops Don’t Follow – Caution!

By Adam Thurgood on May 30, 2023

Legendary Wall Street strategist Bob Farrell is known for many contributions to the profession, but perhaps his most important contribution is his ten rules of investing.  I won’t go into all of them here (you can do that by clicking on the link), but I will highlight one; “markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.”  In simple terms, bullishness is warranted when a large number of stocks are participating on the upswing.  Today, that’s not the case, at least in the U.S.

One way to assess the breadth of a market is to look at the percentage of stocks in an index that are trading above the 200-day moving average.  Over the past 50 years, the S&P 500 has averaged 63% of stocks above the 200-day moving average.  When the index has more than 63%, that’s typically been indicative of a strong market.  Today, just 41% of stocks are above the 200-day moving average.  Not exactly a strong endorsement of the current rally.

With the S&P 500 up nearly 10% for the year, one might ask how that’s possible.  Without getting too much into the weeds, the S&P 500 index uses a market cap weighting methodology, which means companies’ weights in the index are determined by the total value of their shares.  Companies like Apple and Microsoft hold a large weight in the index, 7.4% and 7.0% respectively.  Smaller companies like Caesars Entertainment, which is still quite a large company, carry small weights (<0.04%).  This weighting methodology means that the largest companies, which we will call the generals, can greatly influence the performance of the index.

Today, the generals of Apple, Amazon, Google, Nvidia, Facebook, etc. are charging full speed ahead, with no regard to valuation.  However, the other 490-ish companies in the S&P 500, on average, aren’t performing well.  This can be seen in crystal clear fashion in the chart below, which shows the performance of the S&P 500 (orange line) versus the equally weighted S&P 500 (blue line).  The spread of 10 percentage points is a massive differential and in pure violation of a strong market.  The troops just aren’t following the generals higher.

We saw a similar story play out in early 2000, with large U.S. tech companies surging while the equally weighted index languished.  At the peak of the market in March of 2000 the 6-month spread had blown out to nearly 15%.  A year later, that spread had not only reversed but blown out to nearly 20% in the other direction.

On the flip side, the international markets look much healthier under the surface.  Using the MSCI EAFE index as a proxy, which is a broad index of European, Australian, and Japanese companies, we can see that over 70% of the constituents are above the 200-day moving average. 

In addition to market breadth, the spread between the equally weighted index and the market-cap weighted index is much tighter (1.7%).  This makes sense when you look under the hood.  The international market is not dominated by a few large names.  In fact, the largest company in the index is Nestle with a 2.2% weight. 

On a US dollar basis, both the S&P 500 and the international market have both returned about 10% for the year.  However, one is doing it on the back a few giant names and the other is rising in broad based fashion.  The healthy nature of the international market gives us comfort while the US market requires a frequent dose of Tums. 

We continue to believe we are in a risky environment, with the U.S. stock market unhealthy under the surface while facing an economic backdrop filled with concerning signs.  We prefer the international markets where valuations are more reasonable and the underlying market dynamics are healthy.  Additionally, being paid 5% to hold dry powder in the form of cash is optionality we’ll gladly take.