Toward the end of 2021, the stock market started to experience a level of volatility not seen for some time. The stock prices of previously high-flying companies such as Facebook were down from their previous highs.
Could this be an indicator of a major downturn?
One signal that many technical stock analysts follow is market breadth. The valuations of most U.S. stock market indices – the Dow Jones Industrial Average being a notable exception – are based on the weighted average of the market capitalizations of the companies that make up the index. The market cap of each company is simply its stock price times the total number of outstanding shares.
For example, the biggest stock in the Standard & Poor’s 500 right now is Apple Inc., whose current market cap represents approximately 6.8% of the total market cap of all the companies in the index. When Apple’s stock price rises by $1, the valuation of the S&P 500 will go up by nearly $7.
By contrast, Under Armour Inc. (one of the smallest companies in the index) represents less than one-hundredth of 1% percent of the S&P 500’s valuation. Even if its stock price were to miraculously jump by $100, that would bump up the index by less than $1.
Market breadth is a measure of how many stocks in an index are actually participating in the movement of that index. Suppose the growth in the S&P 500 throughout 2021 was driven primarily by just a few companies with outsized market caps such as Apple, and most of the remaining companies in the index had negative returns. That could be an indicator that there’s not a lot of support for further increases in market returns, and could even be a warning that the market might be turning negative in the not too distant future. On the other hand, if most of the companies in the index contributed to its price gain, one might conclude that that the overall economy was doing well, a positive sign for continued stock market growth.
According to Yardeni Research, as of this writing approximately 85% of the companies in the S&P 500 have experienced year-over-year price gains. So, it wasn’t just those few big tech stocks that drove its solid gain in 2021. Nearly all the stocks in the index participated in the growth. That certainly suggests that the market remains strong.
Unfortunately, no one – including market breadth analysts – can predict the future. There’s no guarantee that a big downturn is not still looming just around the corner.
So, why am I bringing this up? Just to cheer up anyone who may be worried about market valuations and volatility right now. It’s easy to become discouraged as COVID, inflation and supply-chain issues rage. This is one market measure that is telling us that things are still looking good for investors.
Los Altos resident Artie Green is a Certified Financial Planner and founder of Cognizant Wealth Advisors. For more information, visit How well is the stock market really doing these days?cognizantwealth.com.