As stocks extend their rally in 2023, a wider swath of the market is taking part in the gains, lessening one of the main concerns about the durability of the move higher.
Through the first five months of the year, the overall stock market posted solid gains. However, those gains were almost entirely the result of the biggest names, which some observers dubbed the “Magnificent Seven.”

For most investors, especially those owning index funds that track the wider stock market, their portfolio returns would largely look the same whether a rally was concentrated or broad. But returns were so highly concentrated that observers worried the rally was vulnerable to disappointment among those major stocks. So while some were calling the situation a nascent bull market, there was the risk that the gains could quickly evaporate.
Why broader participation matters

But now more stocks have been participating in the rally, leading market strategists to say the push higher is on more solid ground, even if uncertainties remain.

“I’ve been very concerned that the rally was way too narrow,” says Interactive Brokers chief strategist Steve Sosnick. “One of the more encouraging things now is that it is broadening out.” He explains: “Broader participation implies less risk.”

Stocks are now up nearly 20% from the start of the year, as measured by the Morningstar U.S. Market Index, and 27.8% from their bear market low—well into what many observers would call a bull market.

The rally has been fueled by growing optimism that the U.S. economy can avoid a recession despite the most aggressive series of interest-rate increases from the Federal Reserve in history. And with more evidence pointing toward inflation pressures softening, it’s possible the Fed’s July rate hike could be the last for this cycle.

Against this backdrop, the dynamics of the market’s gains have changed. At the end of May, the Morningstar US Large-Mid Index—a collection of the largest U.S. stocks, one that performs closely in line with the S&P 500—gained 9.6%. However, 9.5% of that gain (or 99% of the total gain) came from the 10 largest stocks. Without their outsized returns, the overall market would have been flat.

In fact, the five largest stocks—Apple AAPL, Microsoft MSFT, Alphabet GOOGL, AMZN, and Nvidia NVDA—were responsible for 78% of the total return. The other two big winners rounding out the Magnificent Seven were Tesla TSLA and Meta Platforms META.

Since the end of May, it’s been a vastly different story. The largest stocks slightly detracted from the performance of the Large-Mid Index during this time, when it returned 8.9%
It’s Not Just Mega-Cap Stocks

At Fidelity Investments, Jurrien Timmer, director of global macro, had also been watching the breadth of the rally as an indicator of the market’s durability. In particular, he was focused on the difference in performance between the most widely watched indexes—where stocks are weighted by market size—and equal-weighted indexes.

The equal-weighted S&P 500 index “appears to be breaking out of a year-long base, and as of yesterday 87% of the index is above their 50-day moving average,” Timmer says. “While the mega caps are still leading, the rest of the market is now following, which is not something we could have said a month ago.”

Using the Morningstar US Target Market Exposure Equal Weighted Index—a collection of the 590 largest U.S. stocks, all of which are weighted equally—this benchmark was up 1.2% through the end of May, compared with the 9.6% gain on the Large-Mid Index. However, since then, the equal-weighted index is up 10.8%, outstripping the 8.9% return on the Large-Mid Index.

Another sign is at the sector level. During the first five months of 2023, the sectors contributing the most to the Large-Mid Index’s performance were technology (7.8 percentage points), communication services, which is home to Meta and Alphabet (2.1 percentage points), and consumer cyclical stocks, driven by Tesla (1.7 percentage points).

Since the end of May, tech stocks are still the top contributor to the market’s gains. In second place are financials, which had subtracted from investor returns during the start of the year but contributed 1.5 percentage points to the index’s gain during the more recent time frame. Since the end of May, JPMorgan Chase JPM stock has led the sector with a 15.6% return. Industrial stocks have also joined the rally, contributing 1.2 percentage points. “We have seen other sectors take the lead, and that’s always very important,” says Sosnick.

Sosnick believes the broadening has helped the overall market performance weather investor disappointment over second-quarter results from Tesla and Netflix NFLX. Despite the good news from the market dynamics, he is concerned about potential headwinds for stocks on the macroeconomic side. In particular, he’s watching for any impact from the resumption of student loan payments, as well as ripples from the widespread heat waves this summer, which could jack up utility bills and divert spending from other areas of the economy, such as back-to-school sales.

David Sekera, senior U.S. market strategist at Morningstar, says that as the market’s rally expands, there remain opportunities for investors.

As of July 21, value stocks were trading at an 11% discount to the fair value estimates assigned by Morningstar analysts, he says, while growth stocks were trading at a 3% premium to fair value and core stocks at a 2% premium. Large-cap stocks are trading at a 1% premium, mid-cap stocks are trading at a 5% discount, and small stocks are at an 18% discount.

“While we have seen the rally broaden since the end of May into value stocks as well as mid-cap and small stocks, based on our valuations, there is still room for that trend to continue,” Sekera says.