“Read my lips: Equal-weighted over cap-weighted index.”
So insisted BofA’s Savita Subramanian on Wednesday, while raising her year-end target for… well, for the cap-weighted S&P 500.
Subramanian’s call received some attention, or about as much attention as you can garner with an FOMC decision on deck. She was emphatic about the likelihood of equal-weighted outperformance.
Needless to say, the equal-weighted index has trailed its top-heavy counterpart at various intervals this year thanks to magnificent gains for the “Magnificent 7.”
Looking ahead, Subramanian wondered “who’s left” to buy the mega-caps. “The S&P 500 is more top heavy than ever and one in five funds has over 40% of AUM in the Magnificent 7,” she wrote, adding that active, long-only funds are Overweight five of the seven titans, but are 16% underweight the equal-weighted benchmark.
Throw in stretched valuations (the P/E gap between the top seven and the median stock is enormous on both a forward and trailing multiple) and you’ve got a decent, relative bull case for the equal-weighted index already.
But Subramanian took it further. BofA’s long-term valuation framework suggests +6% returns per annum for the equal-weighted index versus just +1% for the cap-weighted index, she noted.
As an aside, that uses an “apples-to-apples” (as she put it) lookback, which in this case means since 1990. A longer data history suggests the cap-weighted index has much better, but still inferior, returns (+4%).
Finally (actually not finally — Subramanian’s rationale for the equal-weighted preference ran to eight full pages, but it’s beyond the scope of any single, brief recap), she cited secular tailwinds for the equal-weighted gauge over the tech-heavy benchmark.
“Tech is at the center of US-China tensions and de-globalization is likely the biggest risk to the poster child of globalization, Tech,” Subramanian said, noting that tech “has the highest foreign exposure of all sectors” and its supply chains in China and Taiwan “pose a big risk.”
The old economy, by contrast, actually stands to “benefit from re-shoring.”
The analysis is sound and logical. But for fund managers, the timing is so difficult. If you rotate out too early, your relative returns will suffer. The same if you wait too long.
Brings to mind Chuck Prince’s quote from 2008.
The Seven Galacticos automatically get 24% of every dollar flow into S&P500 index funds/ETFs, and more of flows into Nasdaq index funds/ETFs, and indirectly benefit to a similar extent from (long/call) flows into S&P 500 options and futures. Which is a tough advantage to break, in a bull market.
In a bear market, that should work in reverse, although perhaps offset by the MegaTech = The New Defensives dynamic.
In an early (economic) cycle bull market, equal weighted and smaller cap should have an advantage.
Another interesting scenario is if a very large Galactico breaks down in an idiosyncratic way, as even a modest flight of market cap from, oh let’s say AAPL, would be enough to light a fire under the market caps of many other names.
I am, by the way, astonished that one-fifth of funds have over 40% of AUM in the Seven Galacticos. That must be one-fifth by fund count, not by fund assets (?)