Historically, the equally weighted S&P 500 index has outperformed its cap-weighted counterpart by a significant margin. However, last year, this pattern reversed. Is this a short-term development or a regime change? Will small caps stage one of the most spectacular rebounds in the history of the markets?
Below is a chart of the relative performance of the equally-weighted ($SPXEWTR) and cap-weighted ($SPXTR) total return indexes since 1990.
The equally-weighted total return index has outperformed its cap-weighted counterpart by 641%.
Below is a chart of the relative performance of the equally-weighted ($SPXEWTR) and cap-weighted ($SPXTR) total return indexes since March 6, 2009 (the GFC bear market bottom).
The total return of the two indexes is about the same. Note that the equally weighted index has outperformed during the whole period.
However, since last year, there has been a divergence, with cap-weighted large caps outperforming.
Since the start of 2024, the large-cap S&P 500 index total return is up 24.2%, while the equally-weighted S&P 500 index total return is up nearly half of that, at 13.6%.
We will not go into the math details here, but the recent outperformance of the cap-weighted index is statistically significant given the available historical sample, at least since 1990. Therefore, the outperformance is probably a short-term phenomenon. However, in the case of small caps, the Russell 2000 index total return’s divergence after 2021 appears to be statistically significant.
Although until about 2021, the total return of the S&P 500 and Russell 2000 indexes was roughly the same, afterward there has been a dramatic divergence that currently stands at a whopping 1.222%. Just to understand the magnitude of this divergence, small caps would have to rise about 56% while the S&P 500 stays flat to catch up. The question is: Will small caps stage a spectacular rebound? The answer is complicated. If this happens, it will be one of the biggest market rebounds ever.
Higher rates and a regime that promotes concentration and consolidation pose a challenge for small caps, while the advancements in AI pose a threat to the survival of numerous small companies. Rapid rate decreases would benefit small caps, but at the same time, the cap-weighted large caps, led by the magnificent 7, will likely continue to rise, thereby maintaining their divergence. A new economic model is necessary for small caps to thrive, yet it remains elusive.
Conclusion
The equal-weighted/cap-weighted divergence in large caps could be a temporary phenomenon.
The large-cap/small-cap divergence could become a permanent regime change if the economic model does not change.
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Charting and backtesting program: Amibroker. Data provider: Norgate Data
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