Dispelling The Myth About Market Leadership

Includes: MCD, SPY
by: Comanche Peak Investments

The top 10 stocks making up the bulk of the market performance is not abnormal.

Market breadth looking at historical data is not relevant.

Quality stocks provide cover.

One of the constant refrains in the marketplace these days is that there is danger embedded in the lopsided performance inside of the S&P 500 (NYSEARCA:SPY). The top 10 performers account for over 50% of the market's return this year (the exact percentage seems to oscillate between 51% and 53%). This data point has been on CNBC, in the Wall Street Journal, and in countless research products. When these stories first started to take hold back in April, a WSJ article referenced work done by AQR, the giant quant fund manager. AQR, run by the indomitable Cliff Asness, assessed the long-run average of the top 10 stocks to be about 45%. The article writes this as though today's 53% makeup is largely outside of the norm. Cliff responded to the article with a simple tweet.

Now it has been another six weeks, so perhaps this might turn into a more robust anomaly. And even Cliff second guesses his precise use of 45% (but he does refute the whole notion that the top of an index should not be its leaders). But I think the point is clear: we should not be as shocked by the headline figure as many would like us to be (those being the ones in the business of selling headlines).

A corollary of the "top of the market is too thin" theory is that the general market breadth is deteriorating. James DePorre (whom I just started following but seems to be fairly level headed in his analysis) of TheStreet.com likes to point out that the percentage of stocks in the S&P 500 that are trading above their 200-day moving average has fallen from over 70% to about 55% today. I cannot argue with the math. But I would point out that 200-day moving averages do not mean much for today's actual prices. This is especially true when that 200-day period engulfs one of the craziest and surprising elections of our time. I am not trying to dismiss technical analysis in its entirety. I just think a far more useful exercise is to examine the fundamentals of the individual companies and the macro backdrop (simply economic growth and political stage).

Another area that needs to be examined to debunk the narrowness of the market myth is the mutual fund weightings of stock ownership. It comes as no surprise that Technology is the most heavily overweight sector. The detail is not broken down my individual names, but the popular FANG subcategory remains the most overweight. Now, of course, much has been written about the rise of passive investing and its influence on performance. That is, passive investing is simply market cap investing which can create a feedback look. The warning goes that once these inflows into ETFs stop, these highflying names will fall back to earth more rapidly than their ascent (aka the market takes the stairs up and elevator down). But where this logic falls flat is that there are plenty of quality companies with good performance that funds are massively underweight. The best example of this is McDonald's (NYSE:MCD). Its relative weighting is only 0.42 with only 19% of funds owning it (according to FactSet Ownership). And yet MCD is up 28% YTD. Without going into the merits of the MCD stock (I personally like its return to its roots as well as embracing the digital and delivery world), it is quite plausible for an active manager to make this rotation. Put more simply, if the leading stocks were to falter, a rotation among stocks is a more realistic outcome than a directional firesale of the market.

Another angle that I think shines some light on the underlying strength in the market is the Factor performance. According to Merrill Lynch, High Quality stocks outperformed Low Quality stocks by about 1.1% this year. Furthermore, low beta stocks have outperformed high beta stocks by 2%. The broadly defined risk factor has underperformed all styles year-to-date. A common fallback for investors is whether they can "sleep at night" with their positions. Quality and low beta stocks typically fit this bill. Managers are not loaded up akin to the "Dash for Trash" and other momentum styles of tactical trading strategies.

This is not to say that the market cannot or will not experience some weakness in the near future. It is entirely plausible for earnings to slow or the economy to languish as it did in the first quarter (today's weak NFP number does not help). But to say the market is poised for trouble because of the math involved in index performance calculation is pure folly. Do your homework and do not blindly buy what the financial media is selling you.

Disclosure: I am/we are long SPY, MCD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.