The greater the number of stocks participating in a rally, the healthier and more sustainable it becomes. The reverse case – fragile rallies driven by a few large-cap stocks – often leads to painful, portfolio-killing corrections, as investors learned at the end of the tech bubble.
One of the best ways to track this phenomenon is by comparing the performance of the market-capitalization weighted S&P/TSX Composite (the usual, most often quoted index) and the equal-weighted S&P/TSX Composite. In the latter case, a 10 per cent rise in a small-cap stock affects the index in exactly the same way as a 10 per cent jump for Suncor Energy Inc.or Bank of Montreal does.
When rallies are broad-based and a lot of companies are rising, the equal weighted index will closely track the primary, cap-weighted benchmark. Conversely, when market performance is driven by a few, large cap names (like Nortel Networks, for instance) the cap weighted index will leave the equal weighted benchmark in the dust.
The chart below shows the progress of $10,000 invested in each of the equal weighted and cap weighted benchmarks. The bars show the difference in dollar value of each investment over time – the value of the $10,000 S&P/TSX Composite minus the value of the equal weighted TSX investment.
The clear tendency is that periods of sharp outperformance of the cap weighted benchmark (the bars on the chart are increasing in size) are followed by market corrections. This was the case in March 2013, mid-May 2013 and November 2013.
The April to June period is particularly notable. Poor performance by the equal weighted benchmark indicated that fewer and fewer stocks were moving higher. As a result, the dollar value difference between our two hypothetical investments doubled from about $300 to well over $600.
The resulting correction that began May 24 saw the S&P/TSX composite fall 511 points or 5.3 per cent.
Recent market activity has been a bit different, but positive for investors. The cap weighted benchmark outperformed significantly during the month of May, largely driven by telecom stocks, but the subsequent market pullback was a mere blip at 0.7 per cent.
The equal weighted benchmark has climbed 5.1 per cent since the end of May, gaining ground on the cap weighted index. This is an excellent sign the overall market rally is sustainable – more domestic stocks are participating.
Index investors holding the entire S&P/TSX Composite can rest a bit easier. Individual stock pickers can be more optimistic on the prospects for smaller cap, attractively valued stocks for as long as the trend of more stocks joining the rally party lasts.