US Equity Market Breadth: The Problem and the Outlook

Disclaimer: This article is for informational and educational purposes only. It does not constitute financial, legal, or investment advice. Views are based on public information as of the publication date and are subject to change.

Summary in three points

1. A handful of companies with strong earnings are holding the index up, while high rates weigh on everything else. The higher rates go, the wider the gap.
2. Breadth only recovers through a rotation out of the Mag 7 into the rest of the index. That rotation needs lower rates, and rates aren’t falling.
3. The base case is a range-bound market. The main risk comes after the November midterms.

Where the market stands

The S&P 500 is about 1% below its record high, while its median constituent is 16% below its own 52-week high. Goldman Sachs calls this the weakest breadth since the dot-com bubble.

The index looks calm because money is moving between stocks rather than out of equities, and those moves cancel out at the index level. Over the past month, the S&P 500 moved 0.7% and the average constituent moved 8.5%.

In other words, if you look at the index, it barely moved. But if you pick a random stock, it has declined a lot.

One rate, two outcomes

Earnings are holding the index up. Q3 S&P 500 earnings are expected to grow about 29% year over year. Most of that growth comes from AI-related companies, which make up nearly half of index market cap.

Rates are holding everything else down. In September the Fed hiked for the first time since 2023 and signaled one more hike this year. The 10-year Treasury yield reached its highest level since 2007. The same rate affects the two groups differently:

1. Hyperscalers hold large cash balances and earn high returns on AI capex, so they can absorb a higher cost of capital.
2. Small caps, homebuilders and consumer names borrow at short-term rates, so each hike raises their costs right away.

AI capex is itself pushing rates up. Fed Governor Cook says AI investment is raising construction labor and power costs. Hyperscalers fund about a third of their capex with debt, which puts them in competition with the Treasury for the same buyers.

The faster the AI buildout, the higher rates go, and the harder it gets for the rest of the market to rally.

Breadth needs a rotation

A stock below its moving average has lagged, but lagging stocks catch up only if money rotates into them. A rotation needs two conditions, and only one is in place:

1. A reason to sell the Mag 7. This is starting to show up. Hyperscaler capex now absorbs nearly all of their operating cash flow, and their CDS spreads have widened relative to banks’.
2. A reason to buy the rest of the index. This is missing. As long as rates stay high, those companies keep facing high funding costs and valuation pressure.