The purpose of the stock market is to allocate capital according to an ever-changing optimum among three variables:
1) The return on invested capital of an asset.
2) The growth rate of the ROIC on this asset.
3) The market price of the asset.
Identifying this optimum at any one point in time is hard. Imagine that like many investors I conclude that I am not equipped to do all the work necessary to identify and build an optimum position. Is the solution to index my portfolio? The answer is: it depends how I do it.
If my objective is to capture the long-term growth of US companies, then in broad terms I have a choice between two indexes:
- The equally-weighted S&P 500
- The capitalization-weighted S&P 500
In each case, I will own exactly the same companies. The difference is that in the first case, each company will make up 1/500 of my portfolio by value; in the second case, a third of my portfolio will be concentrated in just 10 stocks. Historically, which has been the better strategy? The answer is shown in the upper chart that follows.
Source: Gavekal Research
Two observations leap out:
1) Over the long term, the equally-weighted index has outperformed the cap-weighted index by 1.2% per year.
2) However, there have been two periods—from 1994 to 1999 and again from 2017 to 2022—during which the cap-weighted index massively outperformed the equally-weighted index.
I have argued before that Buying a market-cap-weighted index is just momentum investing: the higher the price of an asset goes, the more of that asset you buy. And as we know, momentum investing always leads to bubbles. So it should follow that the periods when the cap-weighted index outperformed the equally-weighted index—when there were relative bubbles in the cap-weighted index versus the equally-weighted—should coincide with absolute bubbles in the stock market.
