The Lyn Alden Newsletter is a fantastic read about the current state of affairs and offers tons of valuable information. We highly recommend that you read the whole thing on her website: https://www.lynalden.com/june-2020-newsletter/
For more interesting investment ideas, check out the Capitalist Partners Newsletter
If you are pressed for time, we made a summary with the most important facts for you:
In the world of finance, we’re witnessing an unstoppable force colliding with an unmovable object, and that impact between such massive things is causing all sorts of interesting behavior in the markets.
On the other hand, we have the biggest-ever collective fiscal injection by countries around the world including in the United States, and rapid debt monetization and asset purchases by central banks to facilitate those sovereign deficits and smooth out volatile markets.
The result is that we have very large dislocations, like the stock market soaring on heightened liquidity, and junk bond spreads lower than they would be in a natural market, while the economic situation remains stressed.
As this chart shows, employment levels in the United States have crashed to levels not seen since previous recessions in 2003 and 2009, and yet the stock market itself has reflated nearly back to all-time highs.
The point is, if someone had told you last year that in 2020, we would have a global pandemic, and a global economic shutdown in response to that pandemic, that resulted in the biggest surge in unemployment in the modern era and the most negative quarter for GDP on record, that the stock market would only fall 30-some percent and then be back near all-time highs in three months? Probably not, right? As this next chart shows, the stock market’s rebound and the Fed’s balance sheet rise have been in almost perfect harmony.
This keeps the dollar strong and pushes up the import power of Americans and reduces our export competitiveness, so we gradually stopped making things over the years, not just compared to emerging markets but also compared to wealthy peer regions like Japan and northern Europe.
Equal Weight vs Market Weight I’m watching a number of indicators lately, and one of them is the ratio between the S&P 500 equal weight index and the S&P 500 market weight index.
Most major stock market indices are weighted by market capitalization, meaning that the bigger the market capitalization of a stock, the bigger its weighting in the index.
Apple Inc has a weighting in the S&P 500 that is more than 100 times as big as Nucor Corporation, even though they are both S&P 500 members.
Even compared to other top-100 S&P 500 companies, like Union Pacific Corporation or Texas Instruments, the software titan Microsoft holds a slot in the index that is more than 10x the weighting of either of them.
Nowadays, trading costs are way lower, but that is still how a majority of index funds are weighted.
On the other hand, there are some equally weighted indices.
An equal weight S&P 500 index, for example, weights each of the 500 companies equally.
An equal-weight index has to rebalance regularly to maintain that equal weighting.
Simple funds like Invesco’s S&P 500 Equal Weight ETF exist to track those types of indices.
Since the 1970’s, an index of equal weight large caps has outperformed an index of market weight large caps, according to Wilshire.
Wilshire considers a large cap to be one of the top 750 companies in the U.S. by market capitalization, so it includes the S&P 500 plus about 250 other companies that are on the mid-cap side of the spectrum.
The market weight version produced 11.8% annualized returns over a 41-year period, while the equal weight version produced 12.9% annualized returns over the same period.
A difference of about one percent per year may seem small, but it means the hypothetical equal weight investor has more than 49% more money upon her retirement after 41 years of investing than the hypothetical market weight investor, assuming she started in the late 1970’s when this data set begins.
If we look specifically at the S&P 500, which has market-weight-vs-equal-weight data going back to 1989, we get similar results through the present day in late June 2020: S&P 500 Equal vs Market Total Return However, we can see that there are periods where the market-weight index does way better, and periods where the equal-weight index does way better.
If we view it as a ratio, meaning we take the S&P 500 equal weight total return index and divide it by the S&P 500 market weight total return index, we can see more clearly periods where one or the other outperforms.
Whenever this line is rising, it means equal weight is outperforming, and whenever it is falling, it means market weight is outperforming: SPX Equal vs Market Ratio Those charts show the long-term and a 1-year closeup, respectively.
During the later stages of a business cycle, and particularly during recessions when the market sells off sharply, investors flock to the biggest and strongest companies, and therefore the market weight version outperforms.
On the other hand, during the earlier portions of a new economic cycle, when growth is accelerating, the equal weight version outperforms.
If history is of any guide, if a new business cycle begins, we should likely see the equal weight version outperform in the years ahead, after under-performing for the past several years, and particularly under-performing during this crisis.