Broadening of U.S. stock rally feeds investor optimism

By Lewis Krauskopf, David Randall and Saqib Iqbal Ahmed

NEW YORK (Reuters) - Signs the U.S. stock market rally is broadening from the so-called Magnificent Seven of mega-cap growth and technology companies is bolstering investor hopes for a rally through year-end.

Equities have risen sharply, with the S&P 500 up over 8% in November, on the cusp of a new high for 2023, fueled by falling Treasury yields and cooling inflation readings that could signal the end of Federal Reserve rate hikes. Yields fall when Treasury prices rise, and the lower returns on guaranteed fixed-income investments make stocks more appealing.

While some big investors are skeptical the rally amounts to more than just a year-end rebound, recent signs of market strength include gains in areas that have lagged this year.

In one encouraging sign, about 55% of the S&P 500 were trading above their 200-day moving averages as of Monday. That level breached 50% last week for the first time in nearly two months, according to LPL Financial.

"Breadth is finally starting to broaden out to levels more commensurate with bull markets," said Adam Turnquist, chief technical strategist at LPL Financial. "This has been one of the keys to calling this recovery sustainable."

Among other signs, the equal-weight S&P 500 -- a proxy for the average stock in the index -- rose 3.24% last week. That was substantially more than the 2.24% rise for the market-cap weighted S&P 500, the biggest percentage point outperformance for the equal-weight index in nearly five months. Even so, the S&P 500 equal-weight index has gained just 3% in 2023 against an 18% rise for the overall S&P 500 -- on pace for the biggest such annual percentage-point gap in 25 years.

Much of that underperformance is due to the outsized gain in the Magnificent Seven stocks, which collectively hold a 28% weight in the S&P 500 index: Apple, Microsoft, Alphabet, Amazon, Nvdia, Meta Plaforms and Tesla. Overall, the group of stocks makes up nearly 50% of the weighting of the Nasdaq 100, which is up nearly 47% for the year to date.

Struggling small-cap and bank stocks have perked up, especially after last week's U.S. consumer price data for October was unchanged from the prior month.

The small-cap Russell 2000 is up 5.5% since the CPI data with the S&P 500 banks index up 6.5%, versus a 3% rise for the S&P 500. Year-to-date, the Russell 2000 is up 2%, while the S&P 500 banks index has fallen over 6%.

Mona Mahajan, senior investment strategist at Edward Jones, said an environment that could be conducive for a broadening of the rally "is starting to take shape."

“This environment where rates are cooling, inflation is moderating and the Fed is on the sidelines, that is typically a good backdrop for risk assets,” Mahajan said.

“Typically when rates start to move lower, you get valuation expansion and the areas that we could see some more meaningful valuation expansion is outside of large-cap tech,” she said.

The equal-weight S&P 500 is trading at a 5% discount to its 10-year average forward price-to-earnings ratio, according to Edward Jones.

Still, there are reasons to think that the market rally is not on the verge of a sustained broadening.

Investors will get further readings of consumer confidence and inflation next week. Stronger than expected data could spur a selloff in Treasuries, sending yields higher.

At the same time, the sharp rally in stocks for the week ended Nov. 17 was accompanied by high demand for upside call options, particularly in parts of the market that have underperformed this year, such as the small-caps focused iShares Russell 2000 ETF. Some of that has already started to unwind. "We saw a huge pickup in expectations for IWM, but now those seem to have stabilized," said Steve Sosnick, chief strategist at Interactive Brokers.

The recent surge, which has pushed the broad S&P 500 up approximately 10% over the last three weeks, may not last as investors prepare to close their books for the year, said Jason Draho, head of asset allocation Americas at UBS Global Wealth Management.

"A lot of good news is already priced in and investors may be reluctant to chase the rally," he said.

(Reporting by David Randall, Lewis Krauskopf, Saqib Iqbal Ahmed; editing by Megan Davies and David Gregorio)