(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% 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 borne 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% while the rest of the S&P 500 fell 3.5% 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% on average, compared to a 4.9% average increase among the rest. The breadth helped lift the equal-weighted measure 5% in the first five months of 2016, the best start to a year since 2013, compared with a 2.6 % gain for the S&P 500.
“The bigger companies, they led in the upswing through May of last year and were most certainly the most overvalued,” said Chuck Self, chief investment officer of iSectors. “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%.
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% on an annualized basis, compared with a drop of 6.2% when breadth narrows, data compiled by Ned Davis Research Inc. show.
While more stocks rising is good for fund managers who see a larger selection of winners, it’s great for smart-beta ETFs that exploded in popularity over the last five years. The label applies to a category of ETFs where conventional weighting standards are discarded in favor of equal proportions and often a tilt toward companies with high dividends or low valuations.
Strong U.S. economic data, such as a report Wednesday that showed manufacturing expanded at a faster pace in May, is supporting market-wide gains, said Bryce Doty, senior portfolio manager at Sit Investment Associates, which oversees $14 billion.
“If you see broad improvements in the economy -- housing, employment, earnings, income -- that might be an indicator to go into an equal-weight smart-beta fund,” said Doty. “It’s the type of thing you might see once earnings have bottomed and people become more optimistic about the future. As they say, a rising tide lifts all boats.”
ETFs employing smart-beta tactics have seen assets surge more than sixfold since 2009 to $420 billion, or about 20 % of the U.S. ETF industry, data from Goldman Sachs show. The love affair took a hit in 2016 following the biggest yearly loss for the market-cap-neutral S&P 500 since 2008. Investors have withdrawn $562 million from the Guggenheim S&P 500 Equal Weight fund in 2016.
“Seeing breadth improve is a little contrary to what people were expecting, especially given some of the outflows out of mutual funds and ETFs,” Wiegand said. “They’ve been unloved and unappreciated.”
At the same time, the market may have trouble sustaining gains if the most influential shares aren’t part of the rally, Self said.
“It’s not a good sign that the top companies aren’t leading,” he said. “If the generals aren’t doing well, than the lieutenants and privates are susceptible. You have to put that on the negative side of the ledger.”
Last year, five out of the 10 industry groups saw their equal-weighted measure beat out the traditional index. Off the February low, all but one index are beating their market-cap weighted rival. Without the giants’ burden, the equal-weighted rival of the S&P 500 Information Technology Index has rallied twice as much as the traditional index, reaching its highest level in at least 10 years.
“You had a very significant drawdown in terms of downside in equal-weighted in February, so clearly the snap back has helped,” said James Abate, who helps oversee $1 billion as chief investment officer at Centre Funds in New York. “Historically when you look at this relationship, when equal-weight outperforms, it’s an indication of an overall improving backdrop.”