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Market's Branching Out, but the Leaves Aren't Budding

Industries left behind in the tech frenzy have gained ground, but only the stars are getting much attention.

With the Nasdaq Composite Index plummeting yet again today, leaving it 11.7% off its March 10 record close of 5048.64, you might ask what happened to the resurgence of market breadth.

You might better ask: What resurgence?

The market was generally pleased during March to see investors put money back into industries left behind in the wake of the tech frenzy. But that shift, which started around March 7, didn't result in any real broadening.

The

Russell 2000

is off 10.7% and the

S&P SmallCap 600

has dropped 6.2% in the same period. That trend is also evident in the technology sector, where the approach to tech stocks has been cautious for most of the month. Big-cap performers in the Nasdaq Comp have continued to perform well, but lesser names are still getting scalped.

While this stems in part from quarter-end window dressing, as investors take huge fund inflows and plow them into well-capitalized names like

General Electric

(GE) - Get Report

to show the quarter's best-performing stocks on their quarterly rosters, there are other reasons.

The recent volatility has resulted in an aversion to smaller, less liquid stocks. While the expected strong earnings season could propel smaller stocks in the coming weeks, earnings season hasn't yet arrived. Lastly, the market, although showing much less fear of the

Federal Reserve

, still has to confront the prospect of rising interest rates.

Safety in Good Numbers

So the market is betting on safety in the face of uncertainty. Nobody wants to flee the market completely, so people are buying

Circuit City

(CC) - Get Report

and

Citigroup

(C) - Get Report

, both of which recently reached all-time highs.

The larger-cap names, such as

Dow Jones Industrial Average

stocks, have shaken off the Fed in recent weeks -- the Dow held up relatively well today, for example, with a loss of just 0.4%. But the performance in small-cap indices indicates that the central bank's efforts are causing investors to re-evaluate their forecast for smaller companies.

"I doubt we're going to see

broadening if the Fed continues to raise rates," says Tim Hayes, senior equity strategist at

Ned Davis Research

TST Recommends

in Nokomis, Fla. "Some of the breadth did pick up a little bit, but it's not the sustained improvement that makes you think the market is broadening out before a strong move up."

The Russell could be subject to continued volatility in the coming months due to the polarized nature of the index, strategists say. Its top 50 names by market capitalization were responsible for most of that index's 15% gain during the first two months of the year, while many others languished.

"That's something that, in the long term or next few quarters, penalizes the small-cap class," says Satya Pradhuman, head of small-cap research at

Merrill Lynch

. "If you have more volatility, there's a liquidity premium," making more active, larger issues more attractive.

Second-Tier Stocks

The aversion to lower-tier tech names is a bit more surprising, because fund flows have consistently been directed to technology stocks, which were perceived as immune to rate hikes. Some regard the underperformance as a reaction to the excess speculation that persisted in those stocks, as well as a desire to pump up first-quarter performance.

"There's a recognition by some that the whole gamut were being bid up in a speculative frenzy," says Richard Cripps, strategist at

Legg Mason

in Baltimore. Investors "need to show for the end of the quarter, and what you saw with Abby Cohen highlighted it."

Tuesday, the

Goldman Sachs

strategist reduced her equity allocation to 65% from 70%, but, more notably, is no longer recommending overweighting the technology sector. "If she does not favor overweighting technology, well, if you go to a market weight, what are you going to sell?" says Cripps. "You sell second- and third-tier."

That's evidenced in the S&P 500's software and services sector, where investors are being cruel to be kind. Of the 15 stocks in that sector, five are outpacing the S&P's 11.3% return since March 7, led by the 37% gain in

Adobe Systems

(ADBE) - Get Report

. Five others have lost money since then, led by a 24% drop in

Citrix Systems

(CTXS) - Get Report

.

The computer networking sector shows a similar kind of polarization. Admittedly, there are only four of those companies in the S&P. Three have been in negative territory since March 7, while powerhouse

Cisco

(CSCO) - Get Report

is up 15%. Semiconductor stocks have shown a similar pattern.

"Nasdaq breadth has been really bad," says Larry Rice, chief investment strategist at

Josephthal

. "It's heavily focused into a few Nasdaq stocks, and a few Dow stocks, but it's not a broad advance at all."

The trend is harder to discern in Old Economy industries, unless one looks at the broader averages. Second-tier stocks present in the S&P 500 have risen substantially, mostly because they had taken a terrific beating.

Strategists believe the market won't broaden until the Fed takes its foot off the brakes -- or until earnings surprises start to propel lesser-valued stocks higher.