There's a tough truth under the surface of the 4-year-old bull market in stocks

There’s a brutal truth lurking beneath the surface of the stock market’s four-year bull run.

Since the October 12, 2022 bottom, endless enthusiasm for the AI trade has defined the stock market. It’s also posed uncomfortable questions about just how sustainable a bull rally can be if it’s only being powered by a handful of companies, while the rest of the S&P 500 muddles through.

The concerns about over-concentration have intensified lately. Whereas once the Magnificent Seven was the main engine of stock gains, the market appears to be narrowing even more. Apple, Microsoft, and Nvidia account for about 22% of the benchmark index’s total market capitalization. That’s up from about 14% since late 2022.

Other areas of the market, like memory stocks and other chipmakers have also minted strong gains, focusing the spotlight even more on a handful of companies that are driving the continued hot-streak.

Bad breadth in the AI era

According to Ned Davis Research, market breadth — or the percentage of winning stocks versus losing stocks in the S&P 500 — is at an all-time low for a moment when the index is at records.

And once market breadth starts to deviate from the overall index performance, the S&P 500 has historically peaked in the coming months, the research firm said.

An analysis from the Kobeissi Letter on Monday paints an even starker picture.

“The gap between AI names and the rest of the market is historic,”
the market commentary and research newsletter wrote on X. “Since the start of 2024, a basket of 42 AI stocks has generated 67% of the S&P 500’s price return. In other words, those names have contributed +22 percentage points to the index’s +33% gain over this period. By comparison, the remaining 458 stocks have added +11 percentage points.”

As AI sucks up all the air, stocks in other areas of the market are struggling to stay above key technical levels. The Kobeissi Letter’s analysis went on to note that 84% of S&P 500 companies are trading at least 10% below their all-time highs, putting the majority of stocks in the index into correction territory.

It’s a remarkable statistic at a moment when the overall index price is at a record high, amid war, rising bond yields, and general uncertainty about the economy’s direction.

“The market’s central tension is now clearer. Earnings and AI investment remain powerful supports for growth stocks, but high long-term rates, energy-driven inflation risk and narrow breadth leave less room for disappointment,” Mark Hackett, the chief market strategist at Nationwide, said on Friday.

One interpretation simply says the market is a reflection of where the money is being made. AI and tech companies continue to post stellar earnings. Samsung, a poster child of the AI-fueled memory-stock explosion, said last week it is expecting operating profit of $80 billion for the third quarter. If achieved, it would mark the highest quarterly profit ever for any tech company.

A possible cure for the market’s bad breadth could be falling bond yields. As Morgan Stanley noted recently, breadth worsened after the Fed’s hawkish Jackson Hole symposium, which was a wake-up call for investors and led to rate expectations drifting higher. Since then, spasms in the bond market have driven Treasury yields to 24-year highs, further rattling the outlook for equities.

“If bond volatility subsides sooner, breadth is likely to catch up to index price, driving both higher in the near term,” Morgan Stanley CIO Mike Wilson wrote at the end of last month.

“The near term question for equity investors is whether this spills over to equity vol which has remained remarkably calm during this recent breakdown in breadth and valuations. In our view, that will determine how the divergence between breadth and the index is ultimately resolved.”