It has happened sooner than most expected. Within a mere six months, the S&P 500 (SPY) went full circle and reclaimed February 2020 highs on August 18. Investors who stuck with the broad market index through thick and thin will deservingly take a victory lap that I expect to be well-covered by the financial media channels in the next several hours.
However, not everyone will be celebrating a return to the top this week. In fact, the S&P 500’s milestone could only be achieved due to a feature in the index’s construction: market-cap weighting towards two particularly sectors (technology and healthcare) that, coincidentally or not, benefitted greatly from the impact of COVID-19 on the economy.
Change how one defines “the market” and the climb to the peak will likely last another few days, if not much longer.
The Invesco S&P 500 Equal Weight ETF (RSP) is one of the largest funds of its kind, with about $12 billion in assets under management and a modest management fee of 20 bps per year. As the chart below illustrates, the ETF is still a solid 7% off its all-time highs, more so than the Dow 30 (DIA) and about as much as the Russell 2000 (IWM).
Not only that, the fund has behaved much more erratically than its market-cap weighted cousin lately. Notice how strongly RSP rebounded in June, upon encouraging news regarding COVID-19 treatment, and how quickly it came crashing back down shortly thereafter. The ETF also reached lower in March and set a maximum drawdown of nearly 40% from February peak levels.
The underperformance in 2020 (and through the better part of the past two years) can be easily explained by RSP’s broader and more balanced exposure to the different industries. In particular, cyclical sectors have suffered from investor skepticism during this unusual period in the markets in which few have had strong convictions about the ongoing economic recovery.
Take a look at the pie charts below. Notice how technology (VGT), which has been up 25% YTD, represents roughly twice as much of the market’s total value under the market-cap weight methodology than under the equal-weight approach. Industrials, dominated by unfashionable sub-sectors like defense and transportation, is the largest piece of the equal-weight pie.
(Source: Charts by Invesco, montage by D.M. Martins Research)
Why should investors care?
Much has been discussed about how expensive assets in general, and US stocks in particular, have become lately. The S&P 500 reaching another peak before the recession had time to fully develop will only reinforce the idea of overvaluation.
Not all is lost, however, for investors who subscribe to the ideas of (1) buying the dip and (2) mean reversion. Sure, it may be too late to make most of the money that one could have made during the sharp COVID-19 correction. However, aside from the white-hot tech and healthcare sectors, there might still be gems to be uncovered in areas like industrials and financial services that many have been overlooking.
One approach to betting on these opportunities is to cherry-pick stocks that an investor believes might outperform its peer group. The other, less refined yet simpler strategy is to generally rotate into out-of-favor stocks through an equal-weight index approach.
These stocks may have lagged in performance lately. But many can still stage a comeback to all-time highs once the economy finds firmer footing, offering additional upside opportunity to investors along the way.
Beating the market by a mile
Stocks have been on a choppy ride in the past several months, and the future looks even more uncertain. But all my SRG portfolios have been outperforming the S&P 500 in 2020 and since inception by a wide margin, while also producing far superior risk-adjusted returns.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.