Dana Lyons on Equal-Weighted Averages

Last week, Dana Lyons put out a post titled "Weight Of Evidence Back With Bulls?", where he discussed the relative performance of two equal-weighted indices against their more popular, weighted peers. Specifically, he discussed the S&P 500 Equal Weight (RSP) against the S&P 500 (SPY) and the Nasdaq Equal Weight (QQEW) against the Nasdaq (QQQ).

On top of this, I think Dana gave his readers great insight to exactly why these relationships can be an important indicator of market direction:

"Price or cap-weighted averages can give one a distorted view of the health of the broad market at times if they are being unduly influenced by a relatively small number of stocks. On the other hand, an equally-weighted index can give us a better sense of the level of participation across the entire index. And a higher participation level equates to a healthier rally."

Dana correctly points out that since the December 2018 lows on Christmas Eve, the equal-weighted components have outperformed. and that this is a positive sign for the rally we have seen in stocks over the last few weeks. As you can see in the chart below, RSP has outperformed SPY and QQEW has outperformed QQQ.

But have these relationships, and more importantly the strength of equal-weighted averages versus their "parent" index, made significant progress?

Regarding the S&P 500, while we have seen a nice move upward, I am not convinced there is a long-term, sustainable trend that has begun yet. From my perspective, we still need to close (and hold) above the resistance zone highlighted below in red. Until we accomplish this, there is nothing that says we should be looking for a broad market rally that involves more stocks than less.

From the perspective of the Nasdaq (a very popular index that is geared towards the Technology sector), I also see little proof that this upward move will last longer than a few quarters. Again, there is a big resistance zone that needs to be overtaken.

While both of these relationships have been in downtrends for the last few years, this does not mean broad market averages (the S&P 500 or the Nasdaq, in this case) can't move higher on an absolute basis. As you can see in the second chart, RSP has underperformed SPY since late 2016, but SPY has gained 29% since that peak. Interestingly, QQEW has underperformed QQQ since it's inception in 2006, but the Nasdaq has returned 343% since then. For comparison, the S&P has returned 170% over that same period.

With all of this said, I believe Dana is spot on when he says the relative performance of equal weighted indexes can be a useful signal for market trends, especially in the short- and intermediate-term. But when we are looking at multi-year trends, they give little evidence as to what the overall market is capable of in regards to returns.