Saqib Ahmed Iqbal

NEW YORK (Reuters) – Investors are scrutinizing the stock market’s narrowing breadth and other signs of ebbing risk appetite, as markets digest a hawkish pivot from the Federal Reserve, soaring inflation and concern over a fresh wave of COVID-19 cases.

Only 31% of stocks in the tech-heavy Nasdaq are trading above their 200-day simple moving average despite the index’s 18% year-to-date gain, according to Refinitive data, the lowest level in at least a year. This number is 36% for small-caps.

The stocks in are doing better with 68% trading higher than the moving average mark. Still, just five stocks – Apple (NASDAQ:), Microsoft (NASDAQ:), NVIDIA (NASDAQ:), Tesla (NASDAQ:) and Alphabet (NASDAQ:) – have accounted for about half of the index’s gain since April, data published by Goldman Sachs (NYSE:) earlier this week showed. The S&P is up about 24% for the year and stands near record highs.

A narrowing breadth may indicate that there will be a prolonged period of challenging trading. This could lead to deeper than average drawdowns and poorer overall returns. According to the bank’s analysts, declines could be reduced this time due to factors like strong corporate earnings or a market which may already have priced in a Fed that is more hawkish.

Some are more cautious. Advisors Excel Wealth Management chief investment officer Tom Siomades says investors should be ready for market volatility.

Siomades stated, “If that is not possible for you, then you need to reduce the risk.”

The S&P is up 1.2% and the Nasdaq is off 2.4% this month, as the focus on an increasingly hawkish Fed has dried up risk appetite in some corners of the market. The central bank on Wednesday said it would accelerate the unwind of its asset purchases and it paved the way for three quarter-percentage-point rate increases in 2022, as it fights persistent inflation.

Frazzled nerves have also been apparent in the Cboe Volatility Index, known as Wall Street’s fear gauge, which stands about 5 points higher than its long-term median. The high-growth stocks which thrived in 2020 are now on the decline, as well as many meme stocks that rallied this past year.

In the American Association of Individual Investors Sentiment Survey (AAII), Friday saw a drop in investors’ short-term bullish outlook for the U.S. Stock Market to its lowest level since March.

Investors will next week be watching U.S. consumer Confidence Numbers to determine if consumers are shifting their buying behavior in light of concerns about high inflation and COVID-19.

Investors believe that stocks could be at risk from a reduction in breadth.

Peter Cecchini from Axonic Capital, the director of research said, “In order for market to continue it’s advance, it becomes… dependent on fewer and smaller names.” A reversal of performance in names carrying the market’s market share won’t be met with strength in any other market segment.

If investors have a sudden loss of appetite for risk, concentrating on one thing can increase volatility and send them all to the exits.

Siomades from Advisors Excel Wealth Management stated that the door may not be large enough to allow everyone to get out quickly.

Recent elevated volatility is beginning to be reduced, there are some signs. According to Garrett DeSimone (head quant at OptionMetrics), volatility expectations in derivatives markets are falling between Christmas Eve and New Years.

This roughly corresponds to a strong market period. Since 1945, the S&P has gained an average of 1.2% in the last five days of December and the first two days of January, according to data from CFRA, a phenomenon some investors have dubbed the Santa Claus rally.

BoFA Global Research’s survey of global fund managers revealed that cash allocations have been at their highest levels since May 2020. The bank stated that high levels of cash in the past have been an indicator of stocks’ strength.

A narrow stock market breadth may continue over long periods of time and it doesn’t necessarily indicate that a sharp fall is imminent.

Breadth in the S&P 500 narrowed for most of the second half of the 1990s, before the dot-com bubble burst around the turn of the century and during the latter part of the last decade, analysts at Capital Economics wrote.

Andrew Thrasher (a portfolio manager with Financial Enhancement Group) believes market breadth is indicative of market condition, but it does not constitute a trading signal.

The past year “has been a poster child example of a market that can bend due to narrow breadth but not break as a result of it,” he said.