The recent technical progress on the Equal Weight S&P 500 (SPW) has been overshadowed, as only four stocks, including NVIDIA (NVDA), have accounted for more than half of the S&P 500’s total return this year, with NVIDIA alone contributing about one-quarter. As the name implies, each stock on the SPW is equally weighted, as opposed to the market-cap-weighted S&P 500 Index (SPX). The equal weighting eliminates the distortion of the mega cap components and significantly changes several sector weightings, including technology, which drops from around 30% on the SPX to only 13% on the SPW. The industrials sector has the largest increase in weighting, jumping from 9% on the SPX to nearly 16% on the SPW.
The chart below highlights the improving technical setup for the SPW. After a brief consolidation phase following a sizable rally into year end, the index has climbed above resistance from the 2023 highs. The recent breakout from the bullish flag pattern, coupled with positive momentum, suggests a retest of the January 2022 record high of 6,665 is likely.
Source: LPL Research, Bloomberg 02/22/24 Disclosures: All indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results.
It’s All Relative
While the SPW is making technical progress in absolute terms, its relative strength compared to the broader market has been underwhelming. The chart below compares both indexes in a ratio chart, used to identify relative trend direction and strength. When the ratio chart is rising, the SPW is outperforming the SPX, and vice versa when it is declining.
Currently, the ratio chart remains in a downtrend but is near a key support level dating to the pandemic-era lows. Furthermore, and as highlighted in the bottom panel, the 52-week rate of change (ROC) for the pair recently dropped to -13%, a historically low level only exceeded in April 1999. Given the stretched rate of change to the downside and the fact that the SPW vs. SPX ratio chart is at a key support level, LPL Research suspects this could be a logical spot for at least a rebound in SPW relative strength
Summary
A rebound in relative strength for the SPW does not automatically mean the SPX will trade lower, although it would likely come at the expense of mega cap leadership, which may be due for a breather from the heavy lifting these stocks have done for the market over the last year. In addition, technical progress and improving relative strength for the SPW suggest the average S&P 500 stock is doing quite well and that the market is broadening beyond the closely followed mega-caps.
LPL’s Weekly Market Performance for the week of March 8, 2024 highlights a mid-week record for the S&P 500 Index, higher gold prices, and Federal Reserve News.
Stocks have had a tremendous run since last fall (at least until yesterday), with four straight positive months, a series of record highs for the S&P 500, and, finally, one for the Nasdaq, and a more than 20% advance for both indexes.
When stocks do this well, we inevitably hear warnings about high valuations from strategists and pundits. For LPL Research, valuations and corporate fundamentals are major inputs into asset allocation decisions, so this is not intended to dismiss its importance. But good investment decisions, particularly over the short-to-intermediate term, are more comprehensive and incorporate several different disciplines — including technical analysis, in our opinion. Why is that so important? A big reason is traditional valuation metrics have historically not been good indicators of short-term performance.
A scatterplot chart with the S&P 500 Index price-to-earnings ratio (P/E) on the horizontal (x) axis and subsequent one-year return on the vertical (y) axis illustrates this point. If this relationship was well correlated, then the dots would form a downward-sloping pattern from upper left to lower right, indicating higher valuations precede lower returns, and vice versa.
But this scatterplot, including data back to 1990, shows no relationship whatsoever. Essentially, P/E offers very little insight into whether stocks will do well or not in the coming year.
P/E Ratios Have Not Historically Been Good Predictors of One-Year Performance
Source: LPL Research, FactSet 03/05/24 Disclosures: Indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results.
If you are searching for the downward-sloping chart pattern described above, where higher valuations precede lower returns and vice versa, you need only extend the time horizon. When comparing P/E to subsequent 10-year returns, you will notice that predictive pattern — the dots start in the upper left quadrant with low P/Es preceding higher returns, and move to the lower right quadrant, signifying higher P/Es, and lower subsequent returns. In other words, valuations are important for long-term buy-and-hold investors, but not so much for traders or your typical tactical asset allocator.
The current P/E for the S&P 500 is near 23 on a trailing 12-month basis and suggests modest, low-to-mid-single-digit returns over on the next decade. That forecast may end up being overly pessimistic given the potential for a further structural shift higher in valuations as in prior decades, but it does suggest that another decade of double-digit annualized returns, which investors have enjoyed over the past 10 years, is unlikely.
P/E Ratios Have Historically Been Excellent Predictors of Ten-Year Performance
Source: LPL Research, FactSet 03/05/24 Disclosures: Indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results.
Tying this example to the current environment, our message is this. Stock valuations are clearly elevated, especially technology stocks benefiting from the artificial intelligence boom. We’re probably overdue for a pullback. But fundamentals are quite good right now, so these elevated valuations may persist throughout 2024 and potentially even longer. (We wrote about big-cap technology company earnings in our March 4, 2024 Weekly Market Commentary.)
That leaves us watching technical indicators for signs of a breakdown in this market’s uptrend and looking for evidence of fundamental deterioration, which has not yet materialized. In the meantime, LPL Research recommends staying invested and maintains its neutral tactical stance on equities.
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This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.
Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk.
Indexes are unmanaged and cannot be invested into directly. Index performance is not indicative of the performance of any investment and does not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.
This material was prepared by LPL Financial, LLC. All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.
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