Market Extra: One of the biggest problems plaguing the U.S. stock market is getting worse as selloff continues

U.S. stocks have been suffering from “bad breadth” all year, but over the past month, the situation become dire, underscoring some of the risks that arise when the market becomes too heavily reliant on a handful of megacap stocks, analysts say.

On Tuesday the S&P 500 equal-weighted index erased all of its gains for 2023 and tumbled into correction territory, having fallen more than 10% from its July 26 high, according to Dow Jones Market Data.

That is the first time the gauge, which seeks to represent the performance of the S&P 500 index
SPX
if each individual stock was given an equal fixed weighting, has seen a correction since March. A correction is commonly defined as a drop of 10% or more from a recent high.

It isn’t the only major U.S. equity index to have given up all its gains for the year this week. Both the Dow Jones Industrial Average
DJIA
and Russell 2000 index
RUT
of small-cap stocks have as well.

The traditional cap-weighted S&P 500 is still hanging on to a 10% gain for the year, having given back roughly half of its year-to-date gains, according to FactSet data. But beneath the surface, many of its constituent stocks are falling to fresh lows.

Dow Jones data showed 56 stocks in the S&P 500 touched fresh 52-week lows on Tuesday, the most of the year so far.

Furthermore, an analysis from Bespoke Investment Group found that the S&P 500’s 10-day advance/decline line has dropped to -1,629, the lowest level in exactly a year. At the same time, the median S&P 500 stock has fallen more than 2%, with 54% of the stocks in the S&P 500 now trading in the red year-to-date, according to data shared by Bespoke.


BESPOKE INVESTMENT GROUP

Paul Hickey, an analyst at Bespoke, added that the 10 largest stocks in the S&P 500 are up roughly 67% on average since the start of the year, while the remaining 490 stocks in the S&P 500 are essentially flat.

That group includes the so-called “Magnificent Seven” group of megacap technology stocks, which includes shares of Apple Inc.
AAPL,
+0.73%
,
Nvidia Corp.
NVDA,
+1.20%
,
Microsoft Corp.
MSFT,
+1.78%
,
Facebook parent Meta Platforms Inc.
META,
+1.54%
,
Tesla Inc.
TSLA,
+5.93%
,
Google parent Alphabet Inc.’s Class A
GOOGL,
+2.12%

and Class C
GOOG,
+2.23%

shares, and Amazon.com Inc.
AMZN,
+1.83%

“The top stocks are still holding up the market and outperforming the rest by a significant margin,” Hickey said during a phone interview with MarketWatch.

But even the market leaders are starting to show signs of strain. On Tuesday, the Nasdaq Composite
COMP
tumbled 1.9%, its biggest decline since Aug. 24, and one of its biggest declines all year. To be sure, as Hickey pointed out, it isn’t unusual for the Nasdaq to see double-digit drawdowns.

After stocks successfully ignored rising bond yields and the Federal Reserve’s hawkish rhetoric for most of the summer, signs that investors are now taking the threat of higher borrowing costs seriously suggest that the pain for stocks could intensify, with even the market leaders feeling the pinch.

“When you see these broader indexes go negative on the year, that fits nicely with the theme of narrow leadership,” said Steve Sosnick, chief market strategist at Interactive Brokers, during a phone interview with MarketWatch. “Much of the market’s gains have been predicated on this narrow group of megacap leaders.”

“But on a day like [Tuesday], when those stocks are down, there is no place to hide.”

If anything, the market’s decline over the past few weeks has only made the market more lopsided. The traditional S&P 500 is outperforming its equal-weighted sibling by nearly 11 percentage points year-to-date, the widest margin at this point in the year on record, according to Dow Jones Market Data.

Some analysts have proposed that megacap technology has already seen their valuations return to more reasonable levels. According to a Goldman Sachs Group analyst, the forward price-to-earnings ratio for the Magnificent Seven has fallen from its summertime peak of 34 to 27.

See: Magnificent Seven tech stocks haven’t been this cheap in six years, Goldman Sachs strategists say

Yet, whether the reset constitutes good value is up for debate.

“They have come down a lot. They are cheaper, but they are not cheap,” Sosnick said about the “Mag Seven” stocks.

The S&P 500 has cheapened, too. Its forward price-to-earnings ratio has fallen to 17.9, which is below its five-year average of 18.7, according to FactSet data.

However, as bond yields climb, the risk-adjusted return that investors can expect from holding stocks has deteriorated to its weakest level in two decades. According to the latest Dow Jones data available, the equity risk premium for the S&P 500 stands at 0.898%, which is the lowest since July 5, 2002.

Much of this has been driven by rising Treasury yields. The yield on the 10-year Treasury 
BX:TMUBMUSD10Y
 jumped 11.9 basis points to 4.801% on Tuesday from 4.682% Monday afternoon. That’s its highest level since Aug. 8, 2007 based on 3 p.m. Eastern Time figures, according to Dow Jones Market Data.

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