Inside Markets — Market Breadth

Market breadth improved over the last three sessions as concentration issues are usually addressed during month/quarter-end pension fund rebalancing efforts.  Portfolio Managers started rebalancing efforts last Thursday (earlier than usual) given Friday’s large option expiration and magnitude of Q2 equity outperformance. Last week, we estimated equity outflows/fixed income inflows could be ~$50B.  The recent underperformance in semis/AI beneficiaries is largely the result of quarter-end rebalancing, while the rotation into value/cyclical groups seemed to follow Friday’s stronger US flash PMI data.  The combination delivered desperately needed improved market breadth, which will likely prove temporary once quarter-end rebalancing efforts are completed.

The price performance of the Russell 2000 (RTY) will continue to inform our broad market outlook.  In our opinion, a break above range resistance at 2140 would be an early signal that investors will begin to ‘look across the economic valley’ to the recovery ahead.  We doubt this happens in the near-term given late cycle dynamics, inverted yield curve and deeply positive real yields.  It’s more likely that the US economy has to first experience a period of economic contraction before the curve steepens and real yields fall.  The economic contraction doesn’t have to be a painful experience for equity investors if the contraction is deemed to be shallow and the Fed is willing to step in with policy support.  In our opinion, the path to near-term rate cuts still runs through weakening labor markets rather than easing inflation pressures.  The severity of labor market weakness and perceived timing of a policy response are critical inputs that should be accurately reflected in the pricing behavior of the RTY.