Investing

Is there a 'hidden bear market'? Understanding the answer can make you a better investor

"You may look at the performance of the S&P and think, 'Wow, all those companies did amazing,' but that's not true."

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Looking at recent returns in the stock market, it's hard to put "2021" and "bear market" in the same breath. After all, the S&P 500 — a benchmark considered a proxy for the broad stock market — returned a robust 28.7% on the year. That's a far cry from bear territory, when stocks decline 20% or more from recent highs.

But market-watchers aren't letting the jubilation of another excellent year for the stocks distract them from the possibility that a bear is out there lurking somewhere, or may even be lurking in some corner of the market.

"You may look at the performance of the S&P and think, 'Wow, all those companies did amazing,' but that's not true," says Peter Mallouk, CEO of Creative Planning. "We had a strong, broad bull market early in 2021, but that started to fall apart in the second half."

In fact, by Grow's calculations, 77 stocks in the S&P 500 ended 2021 at least 20% below recent highs.

Mallouk calls the current divergence in performance between the market's strongest and weakest stocks a "hidden bear market," though he and other market experts don't view it as a reason to panic. Rather, understanding the dynamics of stock indexes can help you calibrate your expectations of markets over time and help make you a better investor.

Here's how.

Understanding market breadth makes you a better investor

When analyzing movements in an overall index, market experts examine the movements in underlying holdings to gauge an indicator known as market breadth, which measures how broadly companies are participating in a particular move.

Healthy bull markets are said to enjoy upward movement from a broad swath of the stocks in an index, while uneven performance is considered an indicator that the broader index's movement upward or downward may not be as strong as it appears.

Today's version of the S&P 500 is top-heavy. The index's top-five companies — Apple, Microsoft, Amazon, Alphabet, and Tesla — account for about a quarter of the index's overall market capitalization, or the total dollar value of outstanding shares. Those companies have performed quite well, submitting an average return of 40.8% in 2021.

That outsize performance buoyed the index last year.

That isn't necessarily a bad thing, says Willie Delwiche, an investment strategist at All Star Charts. "Generals can lead as long as the armies are following," he says. "You run into problems when the generals are advancing and the armies are headed in the opposite direction."

What 'hidden bears' mean for your portfolio

In other words, if the biggest stocks in a particular index are reporting gains while much of the index is declining, it may be a sign of weakness in the upward move, or even of an imminent move downward.

How can you keep track? One way is to keep an eye on stocks making new 52-week highs and lows, with data available on sites such as the The Wall Street Journal, says Delwiche. "Typically, when the S&P makes a new high, that's bullish. Strength begets strength," he says. "But if more stocks are making new lows than new highs, you lose some of that momentum. It doesn't have the same bullish indications."

Another quick and easy way to track breadth is to examine the performance of an "equal-weight" version of an index, which assigns the same asset values to each stock in a given index. If a bull charge is broad-based, the equal-weight version should perform similarly to the traditional, market-cap weighted index.

Currently, neither measure is sending a bearish signal: Notably, 129 stocks recorded new highs during the January 4, 2022, trading session, versus 48 that registered new lows. And the equal-weight version of the S&P 500 sports a one-year return that's nearly identical to its market-weighted counterpart.

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That doesn't mean an extremely top-heavy market isn't worth monitoring closely, says Mallouk. "You may be tempted to put everything in large-cap U.S., but if market history has taught us anything, it's that whatever is outperforming now won't stay there forever," he says.

"Remember, between 2000 and 2010, large U.S. stocks basically earned zero while everything else in the world was positive."

If you're heavily invested in the S&P 500, Mallouk says, it's essential to understand that you're heavily exposed to a niche in the stock market: "Growth-oriented, large, U.S. tech stocks. It's like a segment within a segment within a segment," he says.

If history has taught us anything, it's that whatever is outperforming now won't stay there forever.
Peter Mallouk
CEO of Creative Planning

With the knowledge that some other kind of investment will eventually take the lead, he says, "I think people should be spreading their eggs in a variety of baskets."

That means making sure you're invested in companies of different sizes, types, and geographies, says Delwiche, even if it may feel odd to diverge from what's been working of late.

"People have gotten accustomed to megacap leadership, but history tells us that it doesn't persist forever," he says. "I'd be thinking about tilting away, and selectively going overseas or into small and mid caps might not be a bad idea."

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