What does the collapse of the "breadth" in the U.S. stock market tell the market?

Recently, an unusual phenomenon has emerged in the U.S. stock market: despite the stock indices remaining near historical highs, market breadth is at its "worst level" in history. Some believe that breadth as a price signal may not be as important as it was in the past. However, Morgan Stanley warns that ignoring breadth is often a "bad idea," and this anomaly may signal market risks.

Recently, Michael Wilson, Chief U.S. Equity Strategist at Morgan Stanley, released a report stating that the past week has indicated that breadth has anticipated "the Federal Reserve may not provide as much easing as the market expects."

Investors Focus on Price Momentum, Ignoring Market Breadth Warnings

In fact, the deterioration of market breadth that began in early December has almost coincided with the rise in the yield of the 10-year U.S. Treasury bond. Morgan Stanley points out that when yields break through the critical threshold of 4.5%, interest rates begin to pose a resistance to stocks; when this occurs, the correlation with stock price-to-earnings ratios turns negative.

As investors increasingly tend to regard price momentum as a key factor in their investment strategy, and due to the lack of mean reversion in recent years, the emphasis on rebalancing has diminished, leading to extreme concentration in many stock markets, including the U.S. stock market.

Morgan Stanley believes that this focus on price momentum and the resulting concentration may explain the disconnection between breadth and price, as well as why many investors choose to ignore market breadth warnings until significant market changes occur.

On the other hand, the appeal of large-cap stock quality and momentum strategies, combined with the rise of low-cost passive investment products, has led to a persistent widening of the spread, that is, the percentage of the S&P 500 index relative to its 200-day moving average, compared to the proportion of S&P 500 stocks above their respective 200-day moving averages.

Excess Liquidity Fades, Anomalies May Disappear Simultaneously

It is noteworthy that over the past 25 years, these ratios have typically changed in sync, with only two instances where the S&P 500 index was "high" relative to this breadth indicator, namely in 1999 and from April 2023 to the present.

The commonality between these two periods, in addition to some of the aforementioned driving factors, is that the Federal Reserve and/or the Treasury provided ample liquidity:

In 1999, the Federal Reserve maintained an accommodative policy to guard against year-end Y2K transition risks, and after the New Year, liquidity tightened, causing the spreads of these ratios to narrow rapidly;

The anomaly since April 2023 began with the peak of $2.5 trillion in reverse repurchase agreements (RRP) and the injection of $500 billion in reserves to address the regional banking crisis.

However, the current question is whether a reduction of the RRP scale to zero and a Fed rate cut lower than expected will lead to a tightening of liquidity early next year, thereby narrowing this abnormal gap. On the other hand, if the Fed cuts rates more than expected or ends quantitative tightening, will liquidity still remain strong?

Morgan Stanley believes it is difficult to know, but if the abundance of liquidity fades, the abnormal divergence between breadth and price that many emphasize may normalize. Furthermore, for some high-quality indices, breadth may not be as important as it was in the past.

Based on last week's stock price adjustments, expensive growth stocks and low-quality cyclical stocks seem most vulnerable to the impact of prolonged high interest rates and declining liquidity, as the RRP mechanism is gradually being reduced.

Risk Warning and Disclaimer

The market has risks, and investment should be cautious. This article does not constitute personal investment advice and does not take into account the specific investment goals, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article are suitable for their specific circumstances. Investment based on this is at one's own risk