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This is a highly differentiated stock market. Almost no one anticipated it, and very few people truly enjoy it. However, most people seem to believe that it will soon resolve in a direction that is favorable to them.

The S&P 500 index hovers not far below record highs, yet the median stocks within this index are still experiencing a 16% pullback. This astonishing divergence has been a focal point of discussion on Wall Street. Entering this week, a consensus in the market has begun to form: the cautious gains seen in most stocks last week will help investors who did not place all their bets on large-cap heavyweight stocks to "get out of trouble."

Once, a decrease of 17% in semiconductors compared to their peak values, and 13% in large banks compared to their highs, were seen as dangerous signals for the sustainability of the market leadership structure and this bull market, which has just crossed its fourth year.

But that's not the case now.

Lee Coppersmith, co-head of Goldman Sachs' equity derivatives sales, stated: "According to our preferred Goldman Sachs measurement standards, the breadth of the market has now deteriorated to its weakest level since the internet bubble. The top-tier indices have continued to mask the difficulties in the underlying markets. The most common question clients ask now is whether a narrow market is a warning sign for the broader market. I increasingly tend to think that it is not, and I remain optimistic about the S&P 500 rising over the next 1 to 3 months."

Morgan Stanley equity strategist Mike Wilson has always emphasized that as the range of earnings growth expands, market performance will also spread more widely; however, he points out that the rise in Treasury yields has rewritten this scenario. Nevertheless, he believes there is no need to worry, as by the time the earnings reporting season arrives, most stocks have already absorbed the risks: "Higher interest rates have the most significant impact on ordinary stocks, but the valuation reductions for these stocks have already far surpassed the deterioration in earnings. If yields remain stable and earnings expectations remain unchanged, that will give them room to recover."

Deutsche Bank strategists downgraded their rating on the tech sector on Monday, citing reasons such as overly crowded investor positions, the high bar required to satisfy Wall Street with financial reports, and the sector's recent extreme outperformance which has driven the S&P 500 higher in the past few months.

Nevertheless, this bearish outlook on what is arguably the strongest engine of a bull market has been mitigated by one prediction: a reset in tech stocks will create more room for other parts of the market to perform better. The statement reads, "Given their concentration, periods when tech stocks outperform usually raise concerns about the breadth of the market, and the past two months are no exception. We believe that the rotation of funds to other sectors and small-cap stocks should alleviate these concerns."

Professional investors hope that the focus of funds will shift from stocks with dominant index weights to a broader range of stocks, which is not difficult to understand, as it is truly challenging to outperform the S&P 500. Charts from Trivariate Research show that in the past 12 months, only 34% of large-cap stocks outperformed the S&P 500, which is close to the historical low range for this indicator.

It is worth noting that the periods during which the S&P 500 was more easily outperformed by other investments were often also times when the overall market was under pressure.

Nevertheless, although I would like to say that the popular view that markets will return to mean reversion and shift towards a broader, more “democratic” market is merely a lazy consensus that is unlikely to come true, over the past year, markets have indeed completed this delicate rotation quite beautifully. Mechanized “diversified trading” has continuously provided support for the S&P 500, while also reducing volatility at the index level.

Monday is a perfect example: The two stocks that had the greatest negative impact on the S&P 500 were NVIDIA and Micron, but the gains of Apple and Meta almost completely offset these negatives, helping the index to close almost flat in the end.

I have always believed that a narrow lead in gains is not a problem. In fact, a bull market usually has a dominant theme that drives the index to its potential limit, as long as it does not completely cede its leading position over the long term.

However, this requires that most stocks do not experience significant declines, and such differentiation should not be accompanied by obvious macroeconomic pressures or tighter financial conditions.

We may be approaching a critical juncture in order to avoid such an unfavorable combination. The credit spread has widened, but it has not yet reached a critical level. The weight-adjusted S&P 500 has hardly rebounded from its new relative low point compared to the market capitalization-weighted version, and its position is not far from where the counter-trend rebound began in May. The Russell 2000 index, on the other hand, is precisely near its 200-day moving average.

The XMAG ETF, which is composed of 493 stocks that are not part of the "Big Seven," could emit a potential technical breakdown signal if it falls a few more percentage points.

Market Thermometer

Macro Risk Advisors's John Kolovos uses several data points to reflect what investors are saying and what they are doing.

Kolovos's view on the latest readings is: 'The earnings season couldn't be more important; it has the opportunity to repair the underlying damage. If the indices continue to strengthen in the coming weeks, but there is no significant improvement in breadth, historical experience suggests that the longer this disconnect persists, the more difficult the road ahead will be, and it could even drag down the entire market, including tech stocks.'

Surrounding Wall Street

I was very fortunate to have a chance to watch a preview of “You Can See Everything”, which is a documentary that is about to be released. It tells the story of the infamous founder of Theranos, Elizabeth Holmes, and is directed by Nathan Fielder and Lance Oppenheim.

In addition to the disturbing, immersive portrayal of Holmes and her family in the days before she reported for jail, this film also vividly depicts the entrepreneurial mindset of Silicon Valley – that state of being on the edge between determination and delusion.

Without spoiling the key plot, Holmes and her husband Billy Evans are desperately trying to restart a certain version of Theranos, with a nearly desperate fervor.

This image of tech entrepreneurs who define themselves as always "betting on the company," prone to rapid failure, and striving to defy fate against all odds is related to the broader AI craze. Although large tech platforms in 2022 were extremely profitable, they had become mature and were led by a form of CEO that carried an element of founder worship. To some extent, this has helped shape the current trend in the financial market, which is characterized by high investment, capital intensity, and a focus on "working harder rather than being smarter" as reflected in the AI approach.

This is undoubtedly still a topic of ongoing discussion. Meanwhile, this Holmes movie will be released this Friday.

A few days ago, there was a very detailed and lengthy thread on X that listed various ways in which the AI investment boom could encounter obstacles.

In this episode of the “Money Stuff” podcast, we invited Susquehanna International, the person in charge of market forecasting at Jeremy Maletz. The discussion was very enlightening, providing insights into how one of the most astute trading institutions in the financial industry views these constantly evolving markets.

Closing Market Observation

If the yield on government bonds has indeed peaked recently, and the 10-year yield once rose above 5.3%, then of course the market will gain some breathing room.

I don't believe that the 'equity risk premium' itself has inherent predictive value; it is calculated by subtracting the yield of 10-year government bonds from the forward earnings yield of the S&P 500 to measure the relative attractiveness of bonds versus stocks. Whether this indicator is higher or lower than zero depends more on the absolute levels of yields, as well as whether inflation or stagnation in growth is the main threat.

However, at least this indicates that there is now less relative valuation cushion for stocks.

More importantly for me, is how the stock market will respond to another round of strong profit growth that may emerge in the AI industry chain.

The hardware industry chain, which includes memory chips and related industrial stocks, has seen strong profit expectations, yet valuations have not held up. This indicates that investors may be collectively concerned about "making too much money" in the short term, as well as the sustainability of long-term profit margins.

Moreover, according to Bank of America, except for technology, Mag, and energy, the median company's profit growth is expected to slow from 12% in the second quarter to 7% in the third quarter.

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