A short-term caution sign for stocks

Key points:

• A  relative ratio system for the equal vs. cap-weighted S&P 500 rotates to the cap-weighted S&P 500  
• After similar signals, the cap and equal-weighted S&P 500 index struggled over the next month
• Defensive sectors tend to outperform other groups with a more offensive tilt

The relative ratio between S&P 500 equal and cap-weighted indexes suggests caution

Investors are crowding into traditional safe-haven assets like Treasury bonds and gold as the turmoil in the banking sector brings back memories of the global financial crisis. 

In times of uncertainty, equity investors play it safe by allocating money to the relative safety of the cap-weighted S&P 500, as its index-weighting methodology tends to favor large companies with higher-quality balance sheets. 

On Friday, a trading system that applies a 26-week range rank to the relative ratio between the equal and cap-weighted S&P 500 index triggered a rotation signal in favor of the cap-weighted S&P 500 index. 

What influenced the reversal in the S&P 500 equal versus cap-weighted ratio 

Over the last ten sessions, the cap-weighted S&P 500 Technology sector outperformed the equal-weighted version by 5.4%, representing the most significant spread since June 2020. Investors decided they would rather own a strong balance sheet name like Microsoft versus something else.

Interestingly, during drawdown periods, the flight to safety trade in Technology is more common than expected.

Similar rotations to the cap-weighted S&P 500 suggests short-term caution

When the relative ratio between the equal and cap-weighted S&P 500 rotates in favor of holding the cap-weighted index, the S&P 500 index tends to struggle over the next month. Since 2007, signals have shown a loss in every single case at some point over that time frame. 

Except for a few bear market instances, the long-term results look solid.

The S&P 500 equal-weighted index shows slightly weaker results than the cap-weighted version over the next few months. From a long-term perspective, one would be better off holding the equal-weighted index based on the return and win rate profiles. 

Not surprisingly, defensive sectors tend to outperform groups with a more offensive tilt over the next few months.

What the research tells us...

Investors crowded into the relative safety of the cap-weighted S&P 500 over the last few weeks as stress in the banking industry stirred up memories of the global financial crisis. A switching system that monitors the relative relationship between the equal and cap-weighted S&P 500 rotated in favor of the cap-weighted S&P 500 index. After similar signals, the cap and equal-weighted index struggled over the next month. The near-term caution sign benefited defensive sectors.