The number of new issues hitting new highs can be thought of as bullish breadth. On any one day, the number of new highs could amount to one-half a percent (usually indicative of a bear market) or 12%. The reasons for the changes in breadth are both systemic and economic.

One thing is clear, however:  changes in bullish breadth often lead to changes in market leadership.  The two systemic causes of recent breadth cycles are identified below.

Part of the answer to the current breadth dilemma is the commercialization of investment management, with most large mutual fund complexes now owned by public institutions. Fund managers are in a performance derby and need to “be in” whatever’s working . . . regardless of the risk.  As the technology sector began to rise last October, investors sold off non-tech assets in order to raise money to invest into high-tech stocks and mutual funds.  This is the “brass ring” theory.

Another piece of the breadth puzzle is the commoditization of the equity markets by the move toward indexing, and the availability of exchange traded index funds.  During the stealth bear market of 1994, mega-cap ($20 billion+) stocks so stunningly outperformed the rest of the market that they then became the “new darlings” favored by the momentum players. From 1994 to mid-1999, it was these very large capitalization stocks that were in the vanguard. This propelled the indexes (which are dominated by the mega-caps) higher than they normally should have been valued.  After April 1998, the breadth of the market began to falter. Even the mega-caps began to underperform.  And so in the latter half of 1999 we witnessed another transition, from small to large, from old-economy to technology.  Finally, over the last two months, the momentum institutions began to dump even the bluest of the blue chips in order to ride the technology boom.  When will we return to those wonderful days of yesteryear when stocks sold at prices that reflected their earnings and growth rates?

Market breadth is very highly correlated with changes in long-term interest rates (see chart above), and modestly correlated with year-to-year profit growth. The breakdown in breadth first occurred as we entered the profit decline during the second half of 1998, caused by problems in Asia and South America.  However, as the market recovered from that event (after the Federal Reserve eased), interest rates began to rise.  This was a normal reaction to interest rates that were unusually low during the first half of 1998.  The long term Treasury bond yield troughed at 4.7% in October of 1998 and fifteen months later reached 6.8%, an increase of 45%.  That’s enough to keep breadth at bay.

In any event, it’s now Chairman Greenspan’s call.  Although the bond market has its own vigilantes to direct it, the prospect of Fed loosening (not the reality of it) is what will be needed to free all the stocks of the S&P 500, not just the technology stocks. As of this writing, there is nothing to suggest that the economy is slowing down whatsoever.  The Leading Economic Indicators are telling us that the economy should be healthy through the next six months. Unfortunately, that health has brought on a shortage of workers and certain commodities. The National Association of Purchasing Managers reports that the percentage of manufacturers paying higher prices for goods has increased in fourteen of the last fifteen months, and now stands at a very high level. Moreover, unemployment levels are so low as to enable employees to bargain for substantial raises.  Normally, these costs would feed into the inflation pipeline, but they have not as of now.  However, they are affecting corporate profit margins in service industries that make up 80% of employees on non-farm payrolls.

Although the market has declined precipitously since mid-January, an inspection of each of the sectors that make up the S&P 500 indicates that the trend of most has been downward since last summer.  Excluding the technology sector, the S&P 500 index is down about 14% since mid-August.  Now that longer-term bond prices appear to have bottomed, market breadth should improve. Last week’s announcement of lower than expected employment figures caused a significant relief rally.  Investors construed this information to mean that the Fed would not tighten more than originally anticipated, i.e., two more increases in the federal funds rate target.

Financial, utility, basic industry, and cyclical stocks rallied off their recent lows.  Clearly, these groups are undervalued relative to their near term fundamentals. And indeed higher prices for these sectors are justified, but we’re concerned about how the entire market would react if inflation continues to meander northward and the Fed is called back into action.  Before that occurrence the bond market would undoubtedly reverse its recent course and yields would be headed higher.

The tightening already in place and planned by the Fed will be enough to slightly cool down the economy by next summer . . . but maybe not enough to stem the rising tide of wage and benefit costs. Unlike the rise in short term rates in 1994, there has been no concomitant rise in inventories, i.e., little opportunity for an inventory correction to slow the production cycle.  After a brief slowing to 3.0% GDP growth in the second half forecast for this year, will we return to higher growth rates?  More important, will hourly compensation continue to move up?  Will productivity flatten and cause unit labor costs to rise beyond the 3.2% (read: inflation) forecast for 2000?  After the presidential election will Chairman Greenspan need to more drastically rein in the economy in order to quell his inflation fears?  We think the fears are real enough to keep yields on ten-year Treasuries and short-dated instruments about where they are currently for the next few quarters.  Will that be enough to free the S&P 500? As Standard & Poor’s itself put it, “until the market accepts the possibility of economic strength without inflation, or until inflation related fears are proven justified, Fed fears will remain a significant weight on the broader market”.

It’s true that we have better valuations today on 70% of the S&P 500, but on the portion that is technology (30%), the relationship between earnings and prices appears excessive.  Appearances can be deceptive however.  The profitability of the stocks in the S&P Technology index is rising so quickly that the current price-earnings ratio might be justified.  One part of our profitability index is determined by profit margins.  In  1996, the net profit margin for the sector was 7.05% and the price-earnings ratio was 21.  In 2000, the projected net profit margin for the sector is 12%, and the current price-earnings is 42.  When the decline in interest rates is taken into account, it’s just about right!  It’s those companies without current earnings, and only the prospect of future earnings that concern us.  We believe that bubble will burst at some point next year.  And while this is of little concern to us, it is a major concern of Alan Greenspan’s.  He shouldn’t be holding the rest of the market hostage just because of a handful of overpriced stocks!

                                                                                                                           --  John K. Dolan

March 7, 2000
Treasury Bond (10 Yr.): 6.38%
S&P 500: 1355