Evening Brief – 05.30.23

Market breadth is crucial. A rally with narrow breadth suggests low participation, and the likelihood of failure is typically high. With only a few large-caps (GOOGL, AMZN, APPL, NVDA, META, MSFT) leading the way, the market will struggle to continue its advance. To give the rally more credibility, small and mid-cap stocks must also join.

The ARMS index, a volume-based indicator that assesses the relationship between advancing and declining issues and their respective volumes to determine market strength and breadth, is at its lowest point in almost eight years. An extremely low reading frequently corresponds with a near-term peak in the equity market.

There are currently two factors driving the mega-cap rally. Firstly, these stocks are highly liquid, and managers can quickly move money in and out without significant price movements. Secondly, the passive indexing effect. As investors move money back into the market, it unequally flows into the largest cap stocks.

The unweighted Nasdaq has performed significantly better than the equal-weighted Index so far this year. The spread between the (unweighted) NDX and (equal-weighted) NDXE is currently above 11%, making it by far the largest divergence over any five-month period in the previous 18 years.

The long technology trade is incredibly overbought and overcrowded as the buzz surrounding artificial intelligence (AI) has kicked into overdrive in recent months; strong enough that the SP500 would be down 2% this year without the popular AI stocks (NVDA), not up 8%.

Another speculative frenzy is taking place as investors’ interest in generative AI soars. But it’s important to remember that past outperformances were ultimately unsustainable. Even if this does not imply the market will suffer a mean-reverting event, it does imply that there will, at the very least, be a rotation to other market sectors.