Megacaps are now S&P 500’s curse as smart beta gets payback

Bloomberg

The world is turning upside-down for U.S. equities, with the biggest gains coming from a strategy that has done little of late but deliver losses to investors and taking over market leadership from large technology stocks.
With companies from Microsoft Corp. to Apple Inc. floundering, baskets of stocks that are free of capitalization biases — known among traders as smart beta — are rising twice as fast as their traditional size-weighted counterparts. The S&P 500 Equal Weight Index is up 19 percent since equities bottomed in February, beating the conventional benchmark by the widest margin since 2013.
The reversal of fortunes holds a bullish signal at a time when few can be found, marking a restoration of breadth in a market that saw some of its narrowest gains on record last year. Beneficiaries include the large swath of smart beta funds that seek to neutralize the impact of megacaps, a strategy that saw outflows in the last four months after stumbling in 2015.
“Due to the S&P 500’s market-cap construction, looking back over the last 12 to 24 months, large companies masked a lot of the pain that’s been born by the more common share price,” said Eric Wiegand, senior portfolio manager at the Private Client Reserve of US Bank in New York, which oversees $128 billion. “Beginning to see that broaden out sets a much healthier undertone.”
Wider gains are part of a subtle normalization in the U.S. stock market after its worst start ever, evidenced by a loosening in relative valuations among companies and greater dispersion in price returns. Correlations with oil and currencies have unwound as big-picture concerns such as the global economy, China and the Federal Reserve eased.
Diminished breadth not only crushed size-agnostic strategies in 2015 but meant that megacaps obscured the market’s fragility. Fewer stocks went up, with the 10 biggest by market value rising more than 20 percent while the rest of the S&P 500 fell 3.5 percent on average, the biggest gap since 1999.
Now their dominance is waning. The 10 largest companies in the S&P 500 have gained 2.8 percent on average, compared to a 4.9 percent average increase among the rest. The breadth helped lift the equal-weighted measure 5 percent in the first five months of 2016, the best start to a year since 2013, compared with a 2.6 percent gain for the S&P 500. Futures on the benchmark gauge were little changed at 9:17 a.m. in London.
“The bigger companies, they led in the upswing through May of last year and were most certainly the most overvalued,” Chuck Self, chief investment officer of iSectors LLC, said by phone. “It’s a reversion to the mean when you can get valuations in line.”
Valuations of the 100 biggest U.S. stocks reached their highest level in seven years relative to the S&P 500 at the start of 2016. Since then, the megacap multiple versus the broader gauge has fallen 1.8 percent.
When breadth as tracked by the relative performance of the equal-weight and cap-weighted version of the S&P 500 improves, the market strengthens as well. During periods of broadening gains in the past, the SPDR S&P 500 ETF has returned 9.5 percent on an annualized basis, compared with a drop of 6.2 percent when breadth narrows, data compiled by Ned Davis Research Inc. show.