Spark Global Limited Reports:
The recent sharp sell-off in the US could be an indication of broader weakness in the breadth of the market. Because top-tier index members are so heavily weighted in the index, their strength can give a misleading picture of how the average stock is performing. How indices work: Why do index calculations distort our view of the broader market
Before we move on to market breadth, we should first understand how the S&P 500 works.
The S&P 500 is a de facto measure of the performance of the U.S. stock market. Turn on the news and you’re bound to hear the announcer say something like, “Strong market today, S&P closed up 30 points.” But to understand what that really means, we need to understand that an index like the S&P 500 is a simple calculation.
As expected, Standard & Poor’s manages the S&P 500 index, which is made up of about 500 US stocks that meet certain size and earnings criteria. But every stock in the S&P 500 is treated unequally. The larger the company, the greater the weight of the stock in the index. Predictably, the biggest stocks have the biggest impact on the index’s movements.
Let’s take a look at the top 10 s&p 500 stocks:
The top 10 are all tech companies. The only non-tech stocks are JPMorgan (JPM) and Berkshire Hathaway (BRKA). You could argue that Tesla (TSLA) is not a tech stock, but the market treats it as such from a valuation perspective. These top components (excluding Berkshire Hathaway and jpmorgan) account for more than 25 per cent of the S&P 500, according to Finasko.
What is market width?
Market breadth is a method to analyze the overall strength of the stock market. Market breadth is not measured by a cap-weighted index such as the S&P 500, but by measures such as the number of stocks that rose and fell, or volume on both sides. Because a cap-weighted index like the S&P 500 is heavily influenced by its largest constituents (the top 10 currently account for 28% of the index), it doesn’t give a completely accurate picture of how the average stock is performing. This is especially true at a time when business is dominated by tech giants such as Amazon, Apple and Google, which are squeezing traditional industries out of business every day.
One of the most popular ways to measure market breadth is the advance/decline ratio (ADR), a simple arithmetic formula that divides the number of stocks that rose on a given day by the number that fell that day. Such ratios allow traders and analysts to draw conclusions from converging and diverging market indices and ratios, or “breadth”.
For example, if the S&P 500 index is surging while the adv-and-downside ratio is falling, that suggests a few very strong stocks are driving the gains, while most stocks are lagging. However, it is rare for ADRs to go down when the market goes up, and instead, you will usually find divergence when the market makes a new high.