Burgeoning optimism surrounding impending potential Fed rate cuts and a rotation toward smaller-cap stocks in July may have been short-lived, as global market jitters led to the trouncing of stocks across the capitalization spectrum on Aug. 5, 2024. The S&P 500^® plunged 3%, its largest daily decline in almost two years.

Despite this recent pullback, the outperformance of mega-cap stocks has been one of the most analyzed market themes of the past year, leading to severe underperformance of the small size factor. In parallel, the continuous outperformance of winning stocks across the cap spectrum led to the dramatic outperformance of the momentum factor. The S&P 500 Momentum Index outperformed the S&P 500 by more than 30% through the 12 months ending in July 2024, while the S&P 500 Equal Weight Index, which has a smaller-cap bias by design, underperformed the S&P 500 by 9% over the same period.

Exhibit 1 plots the historical 12-month relative performance for both indices, from which we can glean two observations: the S&P 500 Momentum Index and S&P 500 Equal Weight Index have an inverse relationship, not surprising given the latter’s innate rebalancing mechanism of selling relative winners and buying relative losers, which is the opposite of momentum-based strategies. Secondly, the S&P 500 Equal Weight Index’s outperformance tended to follow after peaks in the S&P 500 Momentum Index outperformance, most prominently after the burst of the tech bubble in the late 1990s, which makes the current environment an interesting one to examine the S&P 500 Equal Weight Index.

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Larger stocks often carry heftier valuations than smaller stocks, and stocks that have fallen in price more than their peers are often more favorably valued as their prices continue to decline. As a result, we can expect the S&P 500 Equal Weight Index, which has a small size and anti-momentum bias, to also have a value bias.

The S&P 500 Equal Weight Index’s positive value tilt is evident from Exhibit 2, which calculates the spread of the index-weighted value score for the S&P 500 Equal Weight Index versus the S&P 500. The spread is generally positive, and we see that the index’s value tilt has increased over the past year, as performance has suffered.

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To provide further historical context, we group our database into deciles by their rolling 12-month change in value spread, and in Exhibit 3, we plot the average change in value spread on the x-axis, and the average relative performance of the S&P 500 Equal Weight Index on the y-axis. We again see an inverse relationship between changes in the index’s value spread and its relative performance compared to its cap-weighted counterpart.

The current environment is situated just past decile 9, indicating that the S&P 500 Equal Weight Index has become relatively more undervalued compared to the S&P 500.

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Whether we will experience a sustained pullback in mega-cap strength or a reversal in momentum remains to be seen. But if history is any guide, a potential decrease in the S&P 500 Equal Weight Index’s value exposure corresponding with relative outperformance would not be surprising.

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