BlackRock: Fear Not A “Narrow” Stock Market

Key points

Global equities’ nearly decade-long bull run is stoking anxiety about its ability to power on. One concern: narrow breadth — a fragile state when a small group of stocks is contributing the lion’s share of market returns, buoying the broader index. We see today’s strong equity performance, especially in the U.S., as broad-based and driven by healthy fundamentals and solid earnings momentum.

The strongest-performing stocks in the S&P 500 this year have lifted the index, masking more muted returns from the median stock. See the chart above. Yet this year’s narrower market leadership is far from extreme. The median stock has delivered positive returns year-to-date, supported by strong earnings – suggesting a resilient market. Contrast this with the extreme disparity between the haves and have-nots in the U.S. market in 1999, before the collapse of the dot-com bubble: The price return of the median stock lagged the index by 21% and earnings-per-share (EPS) growth trailed by 19 percentage points.

Steady as it goes

Today’s U.S. stock market appears to have little breadth — on the surface. The top-10 companies have accounted for 53% of the total return of the S&P 500 Index so far this year, versus 30% in 2017. Yet this says little about the remainder of the index constituents. The median stock’s EPS growth stands at 21%, versus a 20-year average of 0.2%. We are not seeing signs of extremes in the market. Absolute stock valuations globally are within their historic ranges. In the U.S., valuations are above their long-term average, but not excessive beyond a small group of stocks. The 10 stocks with the best price performance in the S&P 500 have a median price-to-earnings ratio of 48 this year on a forward 12-month basis, while the median stock in the index has a multiple of just 17.2. Cross-sectional volatility – a measure of dispersion in returns across stocks – is near its lowest level in at least 20 years across most major regions, according to BlackRock’s Risk & Quantitative Analysis team. This suggests most stocks are marching in the same direction, while outperformance of market leaders has been persistent – driven by strong fundamentals.

We see little evidence of a link between a narrow market and forward equity market performance. The relationship between the share of stocks outperforming the index at any point and market returns one year out is negligible, our analysis of historical data shows. A lack of breadth in declining markets also has little predictive power, in our view. The recent selloff in emerging market (EM) equities was led by a relatively narrow group of stocks, with the 10 bottom performers in the MSCI EM Index accounting for nearly 40% of the hit. A single stock was responsible for 14% of the decline. Yet we see EM stocks supported by attractive valuations and robust earnings.

Bottom line: We do not see narrowing equity market leadership as a warning sign of the market’s health. More important than the number of stocks leading the market is the quality of the fundamentals driving the market. The steady global expansion underpins our preference for equities over bonds, and robust 2018 earnings estimates make the U.S. our favored region.