What does the performance of the US stock market in 2020 tell us about the strength of US companies and confidence of equity investors? It depends on how you slice it. The market-weighted S&P 500 is up 5.6% from January 1 to September 30. Not bad, all things considered. Yet the S&P 500 on an equal-weighted basis declined by 6.6% during the same time, more in line with broader equity markets around the globe. Both metrics are accurate reflections of where we are.
In 2020, the performance of the Standard & Poor’s 500 has been dominated by its largest constituents. As a market-cap-weighted index, the S&P 500 weights companies based on the number of shares outstanding times the price per share. There also is a version of the S&P 500 that equal weights the companies in the index so that they all represent the same contribution to return regardless of their market cap. While the market-cap-weighted version of the S&P 500 is most commonly used as a market benchmark and as a passive investment, the equal-weighted version is considered by some to be a more accurate reflection of how publicly traded US companies are faring across the board.
Divergence of Exposures
Currently, the most material sector differentiation between the two versions of the S&P 500 is found in information technology. Given the significant market capitalizations of Microsoft and Apple, it is not surprising that they would affect sector exposure so much. Companies like Google and Facebook are assigned to the Communications sector, while Amazon is a Consumer Discretionary company.
While the market-cap-weighted S&P 500 and the equal-weighted version tracked each other’s total return closely from 2010 – 2015, since 2016, we have seen material divergence between the two. That difference has been particularly stark in 2020 in response to the pandemic.
From January 1, 2020, to September 30, 2020, the market-weighted index grew by 5.6% while the equal-weighted declined by 6.6%. That 12.2% difference over just nine months is a vivid demonstration of the ways in which the pandemic and its associated economic uncertainty have been accentuating and accelerating the gap between corporate winners and losers.
There are many sound reasons that the dominant companies in the S&P 500 by market weight have been attracting additional investment given societal changes in how we interact and work.
That said, it is important to recognize that the equal-weighted index is much more in line with the recent performance of equities in the US small and mid-cap, Non-US developed, and emerging market asset classes. In short, the equal-weighted index better reflects the economic impact of the pandemic than does the market-weighted version.
We saw a similar disconnect in 1999, when most US companies earned negative stock market returns, but the S&P 500 gained 21% due to a concentration in…information technology stocks. Of course, over the subsequent three years (2000-2002), the equity markets came back in alignment, to put it nicely.
Still, there is no requirement that the two versions of the index revert to past closer correlations. The gap we have seen over the past four years could continue to expand for some time, particularly as the pandemic continues to drive what could become persistent changes in behavior related to how people communicate, shop, and work.