Stock Market “Inequality” Hides A Big Change

By

Jeffrey Kleintop

Jeffrey Kleintop
CFA, Senior Vice President, Chief Global Investment Strategist

Jeff specializes in analyzing international market trends and their financial implications. He's frequently cited in a range of national media outlets including The Wall Street Journal and The New York Times. He has an MBA from Pennsylvania State University.

August 31, 2020
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Stock Market “Inequality” Hides A Big Change

Stock Market “Inequality” Hides A Big Change
  • In the U.S., the biggest market-cap stocks have outperformed the average stock by a wide margin this year.

  • The outperformance by the biggest U.S. stocks is hiding a change in leadership by the average stock: the average international stock has been outperforming the average U.S. stock.

  • The recent imbalances in the stock market can lead to vulnerability; more to the point rebalancing portfolios may be valuable to help balance exposure to U.S. capitalization-weighted benchmarks relative to international stocks.

Capitalization-weighted and equal-weighted stock market indexes typically don't usually drift too far apart. It’s rare that the performance of the biggest stocks pull the capitalization-weighted benchmark away from the average stock in the index, represented by the equal-weighted benchmark—and when they do diverge, it can mask underlying trend shifts. And so it is worth watching when it happens, as it is now.

Inequality in the stock market

In recent years, the performance of the biggest stocks has moved in lockstep with the average stock. That is still the case this year outside the United States. But, in the U.S., the biggest stocks have outperformed the average stock by a wide margin this year, as you can see in the chart below that measures the performance of the cap-weighted index relative to the equal-weighted index for the U.S. and non-U.S. stock markets.

Biggest stocks are outperforming the average stock in the U.S. this year

figure1

Source: Charles Schwab, Bloomberg data as of 8/28/2020.  Past performance is no guarantee of future results.

Sign of vulnerability

Increasing dependence on a small number of big stocks for overall performance can be a sign of vulnerability. While the S&P 500 Index has made new all-time highs in August, most stocks have not—the equal-weighted S&P 500 Index has not made a new high since June 8, with fewer stocks participating in the gains. 

Looking at the past 30 years (the S&P 500 Equal Weighted index data starts in the 1990s) we can see that the year-to-date rise in the ratio of the capitalization-weighted S&P 500 index relative to the S&P 500 equal-weighted index in 2020 echoes those of 1990, 1998-99, and 2008 (indicated by circles on the chart below). What followed those periods? A closure of the gap as the S&P 500 cap-weighted index retreated.

Been here before

figure2

Source: Charles Schwab, Bloomberg data as of 8/28/2020. Past performance is no guarantee of future results.

History is an imperfect guide to how the future may unfold. Yet, it suggests that when the widely-watched capitalization-weighted market indexes deviate from equal-weighted indexes, we should pay increasing attention to what may be the underlying trend in the stock market.

Hiding a change in leadership

The outperformance by the biggest U.S. stocks is hiding a change in leadership by the average stock: the average international stock has been outperforming the average U.S. stock.

We’ve written previously about how new cycles bring new market leadership. For example, the economic cycle from 2009-2020 saw U.S. stocks outperform international stocks, reversing the international leadership of the 2001-2008 cycle, which reversed the U.S. leadership of the 1991-2000 cycle, after the international leadership of the 1981-1990 cycle and so on. 

At first glance, U.S. stocks appear to be outperforming international stocks as this new economic cycle get underway (most global economic data indicate this year’s recession low point to be in April), seemingly a continuation their leadership from the last cycle. But that is only true for the capitalization-weighted indexes. Since the new cycle began, international stocks have been outperforming U.S. stocks, when measured by the equal-weighted indexes as you can see in the chart comparing them below (the MSCI ACWI ex-USA measures all non-U.S. stocks, known as the All Country World Index excluding USA).

Average international stock outperforming average U.S. stock in new cycle

figure 3

Performance for period 4/30/2020-8/28/2020.  Past performance is no guarantee of future results.
Source: Charles Schwab, Bloomberg data as of 8/28/2020.     

In fact, non-U.S. stocks have slightly outperformed U.S. stocks on an equal-weighted basis so far this year, -2.34% vs. -2.89%, as you can see in the chart below.

Non-U.S. stocks outperforming U.S. stocks this year on equal-weighted basis

figure4

Source: Charles Schwab, Bloomberg data as of 8/28/2020. Past performance is no guarantee of future results.

Looking closely

Although it may seem somewhat academic, looking closely at deviations in the market indexes may reveal some trends that aren’t obvious, suggesting potential actions to ensure portfolios remain in balance. 

The recent imbalances in the stock market can lead to vulnerability. More to the point the average international stock is outperforming the average U.S. stock. This suggests rebalancing portfolios may be valuable to help balance exposure to U.S. capitalization-weighted benchmarks relative to international stocks.