Our Worst Tilt of the Year… So Far

At the end of June, the S&P (S&P 500 market cap weighted) was up 15% year-to-date, while the S&P EW (S&P 500 equal weight) was up a rather disappointing 5%. Everybody knows why: the narrow leadership of a few megacaps have been leading this market of late. Nvidia, Microsoft, Amazon, etc. And they carry a much bigger weight in the S&P compared to S&P EW, which by definition is equal weight. Fortunes have somewhat reversed so far in July, with S&P down 0.5% and S&P EW up 1.7%, but clearly, the spread remains in favour of the S&P 500 cap-weighted.

Taking a bit longer view on the relative performance, equal weight won in 2022 and cap-weighted won in 2023. In the chart below, a rising maroon line means equal weight is winning, and a falling line means cap weight is winning. If you take a super long view, the past 25 years or so, performance is roughly tied. Since 1990, equal weight has annualized 10.6% while cap weight S&P has annualized 10.9%.

The equal weight decision was predicated on a market that had become very concentrated in a few names. Sure, some of the names have changed as they used to be the FANG stocks, then Mag 7 and now maybe the horsemen of AI. The challenge is when the S&P becomes very concentrated, it often ends rather poorly for the market cap-weighted index; it is increasingly risky. Of course, we didn’t expect it to go from super concentrated to super duper concentrated as it did. And perhaps it continues like this, given the excitement around AI-related companies.

There have been a few instances historically when the concentration in the U.S. market became so concentrated. The most often referred to is the dotcom period of the 1990s, which led to a seven-year period without the S&P making new highs. The equal-weight S&P did not suffer this drought. It was also seven years when the nifty 50 concentration finally ended in the 1970s.

Maybe there will be another two years of dominance, maybe two months, or maybe the change has started. Nobody knows, but we do know it has added an incredible amount of risk to the headline index. Trees don’t grow to the sky, even if they are great trees.

Of course, everyone says it's all AI-driven, but there are some other factors at work, too. This leadership accelerated in the past few years, and, coincidentally, yields moved higher at the same time. Higher yields, or the cost of capital, have impacted companies differently depending on their business and balance sheet. Those companies that had added a lot of debt during the low interest rate 2010-2020 have suffered. If it was variable debt, it happened really fast. For those with more fixed debt, their pain continues to build as maturities have to be paid off or refinanced higher.

At the other end of the spectrum are these megacaps that carry little debt and often hold large amounts of cash, which for them is starting to actually have a positive impact on the bottom line. Beyond AI, companies with higher financial leverage (more debt) have dramatically underperformed those with low or no debt. The same has played out for consumers, those more leveraged vs. those who are lenders, but we will save that for another day.

Now, with bond yields coming down somewhat and the Fed starting to cut rates soon, financial conditions have been easing. For the megacaps, that isn’t a big deal, but for the majority of the market that has more leverage, that is good news. Add to this, the valuation spread has really gotten extreme, the much-anticipated rotation may be starting to form.

Final Thoughts

While clearly, this portfolio tilt has not worked out as desired, the rationale remains and has, in fact, strengthened as the narrowness of the U.S. market climbs higher. Given the valuation spread and inherent risk in the market cap iteration of the S&P 500, we remain patient (some may say stubborn) with our more positive view of equal weight, perhaps with even higher conviction today.

— Craig Basinger is the Chief Market Strategist at Purpose Investments

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Sources: Charts are sourced to Bloomberg L. P.

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