Bank stocks soared and materials got hammered Tuesday and I jokingly tweeted "Banks enjoying a Nothing Else to Buy Rally." In truth, though, a sustained narrowing of market breadth in this way has dramatic implications for investors, particularly index-based investors, that are both positive and dangerous.
The performance difference between the market cap-weighted S&P/TSX 60 index and the equal-weighted S&P/TSX 60 index is the best way to track market breadth. When the equal-weighted benchmark outperforms, this is a sign that performance and earnings growth is broad – spread across a lot of different sectors. When the cap-weighted benchmark outperforms, this indicates that market performance is narrowing into a smaller number of large-cap sectors.
This chart below compares the value of $1,000 invested in both the equal-weighted and cap-weighted indexes. The difference remains small but there has been a notable catch-up in performance by the cap-weighted index since August, which suggests that breadth is narrowing.
If this pattern of banks wildly outperforming materials and the remainder of the index, the market will begin to look like the S&P 500 in the late 1990s when all investors crammed into technology stocks.
As performance wanes elsewhere, investment assets will funnel into banks and drive valuations (and stock prices) into the stratosphere. Bank stocks, which are already big enough to push the entire benchmark around, will increasingly determine the direction of the S&P/TSX 60 and the S&P/TSX composite. Index investors will do well as banks drive the entire index higher. The equal-weighted benchmarks will trail by a huge margin.
In this scenario, market risk will rise with bank price earnings ratios. After all, the bank stocks would be climbing not because of strong earnings growth but primarily because there's no growth opportunities elsewhere. When earnings growth becomes scarce, market history tells us that price earnings multiples for the few companies capable of growth spike higher.
I'm not predicting this will happen, just using an exaggerated example to show the importance of market breadth in determining valuation levels and index performance. I will note, however, that if my increasingly bearish mid-term view on China proves correct, a large-scale rotation out of resource-related stocks and into the relative safety of banks goes from a possibility to a probability.
To view chart in mobile, click here.
Scott Barlow