The Problems of Narrow Leadership

I’ve been raising concerns about the narrowness of market leadership for the past few weeks. The accompanying RRG chart shows the problem.

I use RRG charts to tell the story. Relative Rotation Graphs, or RRG charts, are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotate to lagging groups (bottom left), which change to improving groups (top left), and finally complete the cycle by improving to leading groups (top right) again.

The RRG chart of U.S. sector returns shows the technical underpinnings of the latest bout of market strength. There are only two sectors in the top half, indicating either leadership or emerging leadership. Technology is the only sector in the leading quadrant. While consumer discretionary stocks are in the improving quadrant, in light of the clockwise rotation shown by sectors, it’s unlikely to move into the leading quadrant if its current rotation pattern holds. All other sectors are in the bottom half, indicating laggings status.

 

 

Emerging Trouble in Tech-Land

The narrowness of sector leadership leaves the S&P 500 vulnerable to a setback should technology stocks hit an air pocket. Already, the tech-heavy NASDAQ is flashing a series of Hindenburg Omens, indicating a bifurcated market that’s susceptible to a correction. While NASDAQ Hindenburg Omens have not been very effective at calling short-term tops, especially in 2024, these clusters are nevertheless warning flags that all is not well in the high octane growth stocks.
 

 

Even the technology sector is exhibiting signs of bifurcation. Large-cap technology is outperforming the S&P 500 (black line, top panel), but small-cap technology relative performance has gone sideways in the past few months. In addition, relative breadth indicators (bottom two panels) are deteriorating.
 

 

 

Bubbly Conditions

The S&P 500 is showing signs of bubbly conditions. An analysis of current valuation metrics compared to the dot-com top shows that valuations are close, but doesn’t exceed the market top in March 2000.

 

From an anecdotal perspective, current conditions are reminiscent of the investment psychology of the late 1990s, but in my opinion there may be more room for the euphoria to run. In particular, the perceptions of stocks were changing as investors grasped growth-related straws buried deep in a company’s operations. Here are some examples from the late 1990s from around the world:

• Hutchison Whampoa, a leading diversified conglomerate in Hong Kong, was trading as a TMT (Tech-Media-Telecom) stock due to the lack of TMT plays in the region because of its exposure to telecom in one of its divisions.
• Mannesmann, an old German engineering industrial company that was originally known primarily for its production of steel pipes, soared to huge heights because of a timely investment in mobile telecom through its D2 Mannesmann division. The company was eventually taken over by Vodafone for its mobile assets.
• The shares of Canada’s BCE, which was known as a boring telephone company, was bid to stratospheric heights because of a partial ownership of telecom equipment maker Nortel Networks. But Nortel stock soared so much that, at the height of the frenzy, an investor could have bought BCE at a P/E valuation of 2 for it wireline assets ex-Nortel.
• A mining company made an investor presentation. As a sign of the times, management felt compelled to include a section called “our broadband strategy”.

 

Fast forward to 2025, some elements of the giddiness are present. Electric utilities, which were thought of as boring income-producing stocks, have suddenly caught a bid because of the voracious power appetite of AI data centres. As well, Walmart is now trading like a stealth AI play because of its AI agent rollout strategy. The crowning headline of the latest bubble was the story of leading AI researchers rejecting compensation packages of over $1 billion made by Meta Platforms.

Simon White at Bloomberg recently pointed out that the aggregate capital expenditures of the largest AI firms is 1.3x its EBITDA, compared to a 50% rate of the companies in the rest of the S&P 100.
 

 

This pace of capex is insane. While I understand the winner-take-all mentality of AI hyperscalers, the company that wins the AI technology race may not necessarily mean its shareholders win the investment race. Sometimes in financial bubbles, investors correctly identify the economic value of a technological innovation but misidentify who will capture that value.
 

 

Time for Caution

I would not be concerned about the narrowness of leadership if there were some indications that other sectors are ready to take up the baton if technology stocks were to falter. But there isn’t. In particular, I have been watching with growing concern the relative performance of cyclical stocks, which did not participate in the August rally.
 

 

In conclusion, the S&P 500 advanced to an all-time high based on narrow leadership by large-cap technology stocks. RSI readings are overbought, and while it’s possible the market continues to advance on a series of “good overbought” readings, a series of negative divergences call for short-term caution. My base case calls for a short-term pullback or consolidation but no major intermediate term top.