What is a ‘narrow market’?

By Mark Burgess | October 11, 2023 | Last updated on October 11, 2023
4 min read
Display of Stock market quotes with city scene reflect on glass
iStock/Nikada

KEY TAKEAWAYS

  • Stock performance this year has been driven by a small group of companies
  • One way to examine market breadth is by comparing the performance of a broad, market cap-weighted index with its equal-weight version
  • The economy can impact market breadth, as less-cyclical businesses, such as big tech companies, can grow earnings in a weak economic environment
  • Narrow markets are often considered more fragile than broader markets, but shouldn’t necessarily be seen as a bad omen

After a dismal 2022, stock markets have roared back this year. The Nasdaq composite index had its best first half in 40 years, posting a 31.7% return for the year to June 30. The S&P 500 was up 15.9% over the first six months. What’s not to like?

One concern investors have raised during this year’s rally is that the gains for both indexes are being driven by a small group of companies. Owing to enthusiasm about artificial intelligence, the outlook for interest rates, and other factors, the so-called “Magnificent Seven” — Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla — have rebounded faster than other stocks. This has led to talk of a “narrow market.”

What does that mean?

One way to examine a market’s breadth is by comparing the performance of a broad, market cap-weighted index, such as the S&P 500 (in which each company’s weight in the index is based on its overall market size) with its equal-weight version (in which each of the 500 companies makes up an equal share of the index).

Subscribe to our newsletters

For example: Apple, the largest company by market capitalization, makes up more than 7% of the S&P 500; in the equal-weight version, Apple’s allocation is 0.2% — the same as the other 499 companies. That means when Apple (and a handful of other big tech stocks) perform well, the main, market cap-weighted index gets a much bigger boost.

A report from AGF Investments published at the end of May noted that the S&P 500’s year-to-date returns were around 10% higher than the equal-weight index — the largest spread at any time this century.

“Moreover, the better these large caps perform in relation to the rest of the S&P cap-weighted index, the greater their weighting becomes, leading to an even greater disparity of returns versus the equal-weighted index,” the AGF report stated.

The spread narrowed slightly over the summer, as more companies contributed positive returns, but widened again in September as bond yields rose.

Another way to examine breadth is to look at the percentage of S&P 500 companies trading above their respective 50-day moving average. A report from Purpose Investments showed that during the very narrow market at the end of May, fewer than 30% of companies were trading above their 50-day moving average. By the end of July, it was closer to 90%.

“This has been helping the equal-weighted index catch up a bit to the more popular market cap-weighted index,” the Purpose report said.

The market’s breadth this year (or lack thereof) has been related to the likelihood of a “soft landing,” or central banks’ ability to bring inflation down to their target range without triggering a recession, wrote Brian Levitt, Invesco’s global market strategist, in a July report. When a soft landing has appeared to be likely, more companies have contributed to market returns; when markets have anticipated a hard landing, requiring more rate hikes from central banks, the number of companies driving returns has narrowed.

“The strong economic data in early 2023 increased the likelihood of additional interest rate hikes and the potential for a recession,” Levitt wrote.

That meant less-cyclical businesses, such as big tech companies that can grow earnings in a weak economic environment, surged ahead.

Lower inflation data and renewed optimism over a soft landing may have contributed to a broadening of the market during the summer.

Are narrow markets a bad thing?

Narrow markets are often considered more fragile than broader markets. This makes sense, as performance hinges on a small number of players.

Levitt noted that markets became more concentrated before recessions in 1991, 2001 and 2008, and before growth slowdowns in 2011 and 2018. He also noted that markets are more concentrated now than they were in 2000, during the height of the dot-com bubble. However, the top 10 companies are more profitable today and have stronger fundamentals, Levitt said.

Brian Belski, chief investment strategist with BMO Capital Markets, wrote in a report earlier this year that, based on previous periods of narrow outperformance, broader markets often hold up well after that outperformance subsides.

“Narrow market breadth in general does not represent a bad omen for S&P 500 performance,” Belski wrote, “despite the contrary narrative being pushed by many investors.”

Mark Burgess headshot

Mark Burgess

Mark was the managing editor of Advisor.ca from 2017 to 2024.