June 23, 2024 – Stock market breadth, which analyzes the number of stocks advancing versus the number of stocks declining, is a time-tested stock market tool that helps gauge investor sentiment and parse emerging risks. Breadth indicators help investors understand the participation level of stocks in market movements and are a critical component of technical analysis.
Low market breadth indicates that a small number of stocks are driving the market’s gains, while most are either declining or not participating significantly. When market gains are driven by a few large-cap stocks, the market may become vulnerable to significant declines if those few stocks falter. This can lead to a more volatile and unpredictable market environment. This dynamic should be concerning to investors for several reasons:
- Low breadth can create a misleading impression of market strength. If only a handful of stocks are performing well, it may not truly reflect the broader economic conditions or the health of the majority of companies in the market.
- Low breadth may suggest underlying weakness, making the market more susceptible to corrections.
- Low breadth can lead to skepticism among investors regarding the longevity of the market rally. This uncertainty can result in increased volatility as investors may react quickly to any negative news affecting the leading stocks.
Currently, stock market leadership is extremely narrow. A handful of AI-adjacent large-cap tech stocks are driving the S&P 500 to new heights, while the vast majority of smaller securities tread water or follow a downward trend.
Since the end of 2021, the average S&P 500 stock has had flat performance, while small cap securities are down. While the broad index hit several new all-time highs this month, more than 60% of its constituents registered a monthly decline.
The second quarter has been particularly extreme with respect to narrow stock market leadership. For example, this quarter, AI market leader Nvidia is up more than 40%, while its Magnificent 7 group of AI-adjacent large-cap growth stocks is up more than 15%. The remaining 493 securities in the S&P 500 are down -2%.
While, for the most part, the Magnificent 7 stocks currently have market-leading margins and earnings growth, their valuations have expanded to reflect their exceptional business performance. A decade ago, the 10 largest stocks traded at a similar valuation to the remainder of the S&P 500. Increased positive sentiment toward the largest stocks has led to a valuation premium of nearly 70% compared to the rest of the index.
Source: BofA
The lack of market breadth, explained by the significant multiple expansion of a small handful of the largest stocks, has created a vulnerability in the broad market index. Should sentiment for AI-adjacent securities turn or should one or more of the Magnificent 7 hit an air pocket, the effect on the broad market index could be considerable. Whether the seemingly unstoppable momentum of large-cap growth stocks continues indefinitely is anyone’s guess, however, investors should consider the scenario in which it slows or even reverses.
One of the ways that investors can counteract low market breadth concerns is to hedge their bets by including short positions to offset the market risk of their longs. Ergo, we highlight one top-decile stock expected to outperform and one bottom-decile stock expected to underperform in this month’s AlphaRank Top Stocks.
OUTPERFORM: Suncor Energy Inc (TSX: SU) is one of Canada’s most prominent companies in the oil and gas sector, involved in the production of synthetic crude from the oil sands. Suncor has shown consistent profitability with robust free cash flow generation. For the first quarter of 2024, Suncor reported earnings per share of $1.41, beating analysts’ expectations of $1.23 and generating $12.5 billion in revenue. The company recently increased its dividend, reinforcing its commitment to returning value to shareholders. It has a strong focus on improving operational efficiency, which has led to better margins and enhanced shareholder value. Suncor earned a return on capital of nearly 25% and trades at just 5.6x EBITDA, indicating a high-quality business with an attractive, below-market valuation. We expect the stock’s positive momentum to continue in the near term. Disclosure: Long SU in the Accelerate Canadian Long Short Equity Fund (TSX: ATSX).
UNDERPERFORM: First Quantum Minerals Ltd (TSX: FM) is a Canadian-based mining and metals company, primarily involved in producing copper, nickel, gold, and zinc. It operates several significant mines, including the Cobre Panamá, Kansanshi, and Sentinel mines. In Q1 2024, First Quantum reported a net loss attributable to shareholders of $159 million, with a loss per share of $0.21. This follows substantial losses in the previous quarter as well, when they reported a net loss of $1,447 million. The company has faced rising operational costs, particularly in copper production. Its cost of copper production has increased due to lower volumes and higher electricity costs, impacting profitability. The Cobre Panamá mine has faced significant regulatory challenges and public opposition in Panama, leading to operational halts. The political environment remains uncertain, posing a continuous risk to First Quantum’s operations in the region. There has been a notable increase in short interest in First Quantum’s stock, indicating that more investors are betting against the company’s future performance. As of May 31, its short interest totalled 4.7 million shares, a significant rise from earlier in the month. Despite these setbacks and risks, the stock’s valuation sits at a relatively unattractive 9.1x EBITDA. In addition, balance sheet issues have forced the company to issue equity capital, expanding its shares outstanding by 16.9% over the past year and diluting shareholders. Given the financial performance issues, operational challenges, political and environmental risks, increased short interest, unattractive valuation, and recent share dilution, we expect the negative share price momentum to continue. Disclosure: Short FM in the Accelerate Canadian Long Short Equity Fund (TSX: ATSX).
The AlphaRank Top and Bottom stock portfolios exhibited mixed performance last month:
- In Canada, the top decile stock portfolio outperformed the TSX 60 by 0.5%, while the bottom decile portfolio outperformed by 5.0%. The top decile basket underperformed the bottom by 4.5% in June, a “squeezy” month in which short selling was quite challenging. Nevertheless, the top decile-ranked stocks have gained nearly 150% over the past five years, while the bottom-ranked have gained just 25%.
- In the U.S., both AlphaRank portfolios outperformed the S&P 500. While the top decile portfolio increased by 5.8%, outperforming the S&P 500 by 0.8%, the bottom decile-ranked stocks gained 5.9%, outperforming the S&P 500 by 0.9%. The top-ranked stocks were effectively in-line with the bottom-ranked last month, however, they have outperformed by approximately 160% over the past five years.
AlphaRank Top Stocks represents Accelerate’s predictive equity ranking powered by proven drivers of return. Stocks with the highest AlphaRank are expected to outperform, while stocks with the lowest AlphaRank are anticipated to underperform. AlphaRank assigns a numeric value to each security from zero (bottom-ranked) to 100 (top-ranked) based on selected predictive factors. All Canadian and U.S. stocks priced above $1.50 per share and $100 million in market capitalization are evaluated. In both the Accelerate Absolute Return Fund (TSX: HDGE) and the Accelerate Canadian Long Short Equity Fund (TSX: ATSX), Accelerate funds may be long many top-ranked stocks and short many bottom-ranked stocks. See AccelerateShares.com for more information.
