Even though the markets have reached new highs, the rise has continued, owing primarily to the robust performance of just a few big companies.
According to Goldman Sachs's analysis, five stocks represent 51% of the S&P 500's performance since April. These five companies are Microsoft, Google, Apple, Nvidia, and Tesla. They made more than one-third of the S&P 500's 26% gain this year.
While this was happening among these well-known tech companies, David Kostin, Goldman Sachs chief U.S. stock strategist, sees diminishing market breadth (or fewer stocks to go up) beneath the surface as a critical threat in the near term. Kostin pointed out that stocks have historically delivered lower-than-average returns and suffered harsher declines after times of dramatically decreased market breadth, such as the current situation.
There have only been 11 occasions since 1980 when the market breadth has closed as much in a six-month period as it did between this year's April and October. Having observed most of these instances, Kostin shows that the S&P 500 returns were below average for one, three, six, and 12 months.
"Previous research indicates that changes in market breadth can be a good marker of stock market returns in the near term," Kostin states. Nonetheless, Kostin thinks stocks are ready to deviate from this historical pattern owing to a number of reasons.
The 'unknown unknowns' is a reason for the greatest drawdowns, and it is impossible to predict them in advance due to their nature. However, macroeconomic data implies that drawdown risks for the upcoming months would be substantial. Despite the difficulty of predicting one, the risk of recession looks to be minimal. Profit margins and earnings are still exceeding estimates. At the same time, despite nominal and real rates rising, they are still projected to be low over the next few months, helping valuations and stock demand, according to Kostin. The analyst is bullish about equities with high-growth potential.
Kostin says that these equities have fared well in previous months and should tend to do so if the decreasing breadth remains. Such companies sell to similarly high-growth corporations with low or negative profitability at a small premium. High margins are a significant indicator, signaling that these equities are likely to outperform their low-margin competitors in the current macroeconomic environment and the context of tighter financial circumstances.
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