Market Observers Can't Decide if Bad Breadth Is a Bad Thing

Average stocks are suffering while a few big winners are boosting indices. Observers, however, differ over whether this is bad news or just another sign of globalization.
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On the face of it, it really hasn't been such a bad year for the market. Even with the recent weakness the

S&P 500

is up 4.6% on the year, while the

Dow Jones Industrial Average

has added 11.4% and the

Nasdaq Composite Index

tacked on 27.8%.

But for people who care about breadth, the market as viewed through the major indices is a bit like a house whose beams are full of dry rot. Who cares if it's got a fresh coat of paint?

It hasn't been a good year at all for the average stock. Of the stocks in the S&P 500, 282 -- more than half -- are 20% or more off their 52-week high. In the last year, 295 have underperformed the index by 10% or more. Of the 1,500 stocks that make up the S&P 500,

S&P MidCap 400

and

S&P SmallCap 600

indices, 881 are down since Jan. 1.

The old saw on Wall Street has it that when the big indices run higher while the average stock beats a retreat, it's the same as an army's generals rushing too far in front of the troops.

"More often than not the generals end up getting slaughtered," says Richard Dickson, technical analyst at

Scott & Stringfellow

in Richmond, Va. "At the least, when you have that kind of situation, you have a high level of risk in the market."

But not everybody subscribes to common wisdom that poor breadth is a red flag.

"To say that you don't have a healthy market because of the breadth -- to me, that doesn't make sense," says Jeffrey Applegate, chief investment strategist at

Lehman Brothers

.

The extreme outperformance of the handful of large-capitalization issues that have helped suspend the major indices, while small- and mid-cap stocks have fallen, jibes with Applegate's view of what's going on in an era of technological innovation and globalization. "You've got a situation where we've created this world of globalism," he says. "The folks that ought to benefit most from this are global players, and that's not small-caps and mid-caps and even a big chunk of the S&P 500."

You may wonder what the technical strategists at Lehman think of Applegate's dismissive attitude toward the market's poor breadth.

The Big Board Runs Out of Breadth ...
10-day cumulative advance/decline line for the NYSE

Source: Baseline

"What Jeff is saying is that one does not have to invest in the broad market to make money," says Steve Shobin, the firm's chief technical strategist. "One need only invest in those stocks with accelerating earnings momentum."

And even with big-cap outperformance this year, by Shobin's reckoning, poor breadth is one of the things that has capped the ability of the S&P 500 and Dow to eke out anything much in the way of returns this past half-year. For stocks to rally substantially, Shobin thinks, the 10-day cumulative advance/decline rate on the

New York Stock Exchange

would have to reach something like 5000. That would give the market the kind of momentum necessary to send it to new highs.

... And the Nasdaq Gasps for Air
10-day cumulative advance/decline line for the Nasdaq Stock Market

Source: Baseline

With breadth figures like the advance/decline line so bad lately, some are starting to wonder if the market's GIs are due for a turn of fortune.

"The obvious question is when does breadth get so bad that you're seeing a bottom," says Peter Canelo, equity strategist at

Morgan Stanley Dean Witter

. Canelo believes the bottom's been laid down. A number of the indicators he watches -- the put/call ratio, tick data -- suggest to him that breadth is on the mend. "As far as I'm concerned," says Canelo, "with breadth, you've seen the worst of it."

If that's true, the U.S. stocks may have experienced what

Salomon Smith Barney

equity strategist John Manley calls "a new-age bear market" where a lot of stocks have gone down, without a tremendous amount of wealth destruction. It may be that the market will get by with just that, but for that to happen, it's crucial that the root cause of the breadth problem -- that "the U.S economy is probably growing at a level that's unsustainable in a noninflationary manner" -- be resolved. Otherwise, it may turn out that the generals really are in for some trouble.

Says Manley: "You're not going to see the big stocks hang on forever if the economy stays too strong."