On February 13, we posted a piece noting that the S&P 500 Equal-Weight ETF offered by Rydex (ticker, RSP) had just broken out to a new all-time high. As a refresher, an equal-weight basis places an equal weighting on each of the components in the index as opposed to placing greater weight on those stocks with the largest market cap. We have mentioned before that a key focus of ours in judging the health of the broad stock market is breadth, i.e., the number of stocks going up versus those going down. We like to see broad participation among stocks during a rally, for example, as a way of gaining confidence in the underlying foundation and sustainability of the up-move. Now there are countless ways of measuring breadth. One way is by using an equal-weight index. If an equal-weight index is performing well, it means that the majority of its components are doing well, i.e., it is exhibiting good breadth. In that vein, it is encouraging to see the Equal-Weight S&P 500 (RSP) hit a new 52-week (and all-time) high versus the cap-weighted index on Friday.
As the chart shows, the ratio of the RSP to the cap-weighted S&P 500 SPDR (ticker, SPY), topped in late June of last year. Ever since it has been unable to make a higher high, despite the series of new absolute highs in the ETF. This was a bit of a concern, as we noted in the February post.
If there is a chink in the armor here, it is in the relative ratio of RSP to the S&P 500 (specifically, we are using the SPDR S&P 500 ETF, SPY). Despite the new high in RSP, its ratio versus SPY has not yet surpassed the high it made last June. We have seen this sort of divergence before (i.e., RSP goes to a new high but the RSP/SPY ratio does not), generally near tops in the market. For example, in 2007 (not shown) the RSP/SPY ratio peaked in February. Meanwhile, the RSP continued to make new highs into June. Of course, the market topped soon afterward.
We also went on to say that in terms of importance, we would place the absolute new high in the ETF ahead of the new high in the RSP/SPY ratio. Price is truth and as long as the price is heading up, the divergence in the ratio is secondary. Presently, we have the opposite situation with prices below their February peak even though the ratio hit a new high on Friday. Our stance on this reverse-divergence is the same. We would prefer that the absolute price of the RSP was also at a new high. However, that doesn’t negate the good news implied by the fact that the S&P 500′s equal-weight to cap-weight ratio is at a new high. Since these types of ratios often lead the market in the formation of their tops, perhaps the best interpretation is merely that THE top in the S&P 500 is not imminent.
Speaking of ratios, we recently penned a piece noting the divergences among 4 other market segments that we interpreted as bearish for the market. This new high in the equal-weight/cap-weight S&P 500 contradicts such negative conclusions. So how do we reconcile the competing messages? We don’t. As risk managers, it is our responsibility to balance, or weight, all of the evidence in framing our orientation toward the market. Rarely – or more accurately, never – is there a consensus among all risk analysis. Therefore, it should not be surprising that we come across a positive development like this, even as there are quite a few strikes on the negative side of the ledger, as we see it.
Having an open mind when analyzing the market is critical. To be a permabull or bear or to have an unyielding opinion on the market is counterproductive. That is because the parts are always moving and facts are always changing. Although, on the other end of the spectrum, one does not want to be so open to inputs that they run the risk of suffering from analysis paralysis. For us, the key in combating that threat is to have an objective investment system or approach. We know what the inputs are that we deem most important and the moves we will make based on how such inputs are reading.
At the present time, while we do have reservations about the longer-term market prospects, there are still plenty of reasons to remain optimistic in the short-term. One such positive development is this recent new high in the S&P 500 equal-weight index versus the cap-weighted index.
“Vintage Scales” photo by Cool Kats Photography.
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The commentary included in this blog is provided for informational purposes only. It does not constitute a recommendation to invest in any specific investment product or service. Proper due diligence should be performed before investing in any investment vehicle. There is a risk of loss involved in all investments.