Stock market hurtling towards disaster, what can save it: Goldman

Reuters / Brendan McDermid

• Goldman Sachs closely monitors a measure called
  “breadth,” which assesses the degree to which the market’s
  returns are being driven by a small handful of stocks.
• The firm’s breadth signal is flashing yellow, and
  investors should be wary of a meltdown.
• There is, however, one surprising market dynamic
  playing out that could help insulate stocks from a surefire
  selloff.

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As the stock market enjoys one of the best
earnings seasons in recent
memory, an ominous situation is threatening to bubble up under
the surface.

It has to do with the market’s heavy reliance on just a small
handful of stocks, bringing a closely-watched measure known as
“breadth” into potentially perilous
territory.

Goldman Sachs finds that the
top 10 contributors have accounted for 62% of the S&P 500‘s 7% year-to-date return,
which has has breadth hovering near the lowest level on record.
And out of those 10 companies, nine are in the tech sector.

This is reflected in the chart below, which shows that a breadth
index maintained by Goldman — which provides readings between 0
and 100 — is currently sitting at, you guessed it, zero.

Goldman Sachs

So what’s the big deal? Allow Goldman to explain.

“From a fundamental perspective, narrow market leadership
typically reflects narrow earnings strength, which is often a
symptom of a weakening operating environment,” David Kostin, the
firm’s chief US equity strategist, wrote in a client note.

What’s more, the decline of breadth to such low levels has
historically preceded meltdowns on both the market and economic
fronts.

The period immediately prior to the tech bubble was marked by
extremely tight breadth, while similar conditions in 1990 and
2008 preceded economic recessions. Breadth was also notably
low during non-recessionary economic slowdowns seen in 2011 and
2016, according to Goldman.

“Usually these narrow bull markets eventually led to large
drawdowns when investors lost confidence in the increasingly
expensive handful of crowded market leaders,” said Kostin.

With all of that haunting precedent to consider, Goldman still
thinks the market can come out OK, at least in the near term. And
that’s because the conditions surrounding this particular
instance aren’t as troublesome as they were during past periods
of turmoil.

It all boils down to the current earnings landscape, which
Goldman identifies as a saving grace of sorts for the market.
While market returns are highly concentrated into a handful of
stocks, Goldman finds that the earnings environment is
surprisingly broad-based.

The top 10 S&P 500 stocks account for just 20% of index
earnings, which is right around average for the past several
years, and just below the 30-year average of 21%, according to
Goldman data.

Going forward, it will be up to investors to continue assessing
the relationship between market breadth and its earnings-specific
counterpart. If corporate profits stay widely distributed by
comparison, it should alleviate some worries that a major stock
selloff is imminent.

It’s when earnings breadth starts dipping that investors should
start to worry, so keep your eyes peeled.