Since the Federal Reserve began raising interest rates in the Spring of 2022, investors have experienced a stock market that can be defined as narrow or lacking in breadth. Look no further than the recent performance differences between the S&P 500 equal-weighted and market capitalization-weighted indexes. Compared to the technology heavy S&P 500 market capitalization-weighted index, the price percentage change of the broader S&P 500 equal-weighted index has been almost flat since January 2022 and modestly positive year-to-date.  (Reference:  Y-Charts.  SPY and RSP, Price % Change.  January 1, 2022 – June 14, 2024). 

Indexes in financial markets can be constructed using various methods, with two common approaches being equal-weighted indexes and market capitalization-weighted indexes. An equal-weighted index assigns the same weight to each constituent stock regardless of its size or market capitalization. For example, the S&P 500 equal-weighted index includes 500 stocks – each stock representing approximately .20% of the index and an equal impact on the index’s performance. An equal-weighted approach generally represents broader diversification and has the potential to outperform the market when smaller companies outperform larger companies. However, these indexes are not reflective of the actual market capitalization distribution of the stock market and tend to underperform in bear markets as smaller capitalization stocks are generally more volatile.

A market capitalization-weighted index assigns weights to constituent stocks based on their size. For example, the top three holdings of the S&P 500 market capitalization-weighted index currently represent approximately 20% of the index (Microsoft, Nvidia and Apple). Moreover, the Top Ten holdings currently represent approximately 34% of the index. Larger companies have a greater influence on the index’s performance. Capitalization-weighted indexes also reflect market trends (recent example – artificial intelligence), which become even more representative of the overall index since it considers the size of companies. While larger companies are generally more stable, there is a higher concentration of risk from market capitalization indexes as a few large companies can potentially dominate the index. These indexes can also underperform in markets where smaller capitalization stocks are the primary drivers of growth. 

The mega-cap technology sector, Magnificent Seven stocks, and more specifically Nvidia, have benefited the most (so far) from an arguably narrow stock market focused heavily on the semiconductor industry, technology and artificial intelligence. As the Federal Reserve continues to weigh current and future economic conditions, waning inflationary pressures and potentially easing monetary conditions, investors may also benefit from broader stock market participation.    

Disclosures 

Past performance is no guarantee of future results.  Investing involves risk, including possible loss of principal.  Diversification may not protect against market risk or loss of principal.  The opinions expressed above should be construed as neither investment advice nor a solicitation to buy or sell securities.  Actual investor results may vary. 

Not FDIC Insured – No Bank Guarantee – May Lose Value