Beneath the Surface of Market Highs

Investor sentiment and stock market valuations are getting increasingly stretched as indexes trek higher, but solid underlying breadth has been a positive offset for now.

As headline stock indexes have marched higher this year (and since the recent October 2023 low) without a serious pullback, investor sentiment has started to look increasingly optimistic and frothy, which we think is a building risk to the market (with caveats mentioned later). Unsurprisingly, those in the trend-following camp have grown increasingly excited as the S&P 500 has taken out its January 2022 high and crossed the 5,000 level.

What the duck

The reality is the stock market is acting a little more like a duck than a bull: calm on the surface but paddling like the dickens underneath (chef's kiss to Michael Caine, who coined that phrase). Check out the performance table below, which is posted on my (Liz Ann's) X feed every morning. Per the third column, the S&P 500 and Nasdaq have suffered no more than a -3% drawdown from a year-to-date high—but that's at the index level. Looking under the surface yields a very different picture. Although not as extreme for the S&P 500, the average Nasdaq member maximum drawdown from year-to-date highs is a whopping -22% (yes, that's a bear-market-level decline).

Major Indexes and Maximum Drawdowns

Glancing at the right half of the table above, you'll see even sharper extremes of churn under the surface. Since the major market lows of October 2022, the S&P 500 is up 44% (far right column), but the index's average member maximum drawdown has been -26% over that same period. In the case of the Nasdaq, those performance numbers are +56% and -54%, respectively.

[There is an important aside with regard to the Nasdaq. Per Leuthold Group research, the number of Nasdaq-traded securities ballooned by nearly 60% (about 2000 new issues) from mid-2020 to mid-2022. Not all of those issues were companies with real operations. Some of them were warrants and others were special purpose acquisition companies (SPACs), which can distort a variety of breadth measures.]