There’s a market-beating strategy that could be a perfect hedge for the latest tech-fueled stock plunge

• The S&P 500 equal-weighted index may provide a hedge against tech-driven stock declines.

• The concentration in tech stocks has led to recent underperformance in the cap-weighted index.

• Lower valuations and broadening growth could fuel outperformance for the equal-weighted S&P 500.

The S&P 500 equal-weighted index, to be frank, has been a rather lackluster way to own the market in recent years.

During the last half-decade, it’s up 63% while the tech-concentrated cap-weighted index you hear about more often is up 93%. In the last 12 months, the equal-weighted index has risen just 2% while the cap-weighted index is up 12%.

The underperformance has a simple explanation. Tech and tech-adjacent stocks have dominated the market, and since they’re the largest by market capitalization, they contribute more to the returns of the cap-weighted index. The equal-weighted index, meanwhile, weights all of its constituents the same.

But with the tech sector and mega-cap stocks selling off this past week, it could finally be the equal-weighted index’s time to shine.

Investors this week balked at lofty tech stock valuations and spending on AI — the Technology Select Sector SPDR Fund (XLK) is down 5.6% since November 3. The underperformance in tech has dragged down the S&P 500 cap-weighted index by 2.7% in that time.

Meanwhile, the cap-weighted index has fallen just 0.4%.

If investors’ retreat from the tech sector continues, the equal-weighted index could be an effective way to hedge downside risk in the cap-weighted strategy, as its performance hinges on the direction of a select few stocks.

“At any point in time you could have a very big drawdown in these stocks, and that would not be unusual because these are volatile stocks,” Hank Smith, the director & head of investment strategy at The Haverford Trust Company, said about AI-focused mega-cap stocks.

“I don’t think a lot of investors understand the risk they’re taking buying the S&P 500 index when you consider 10 names in a 500 stock index represent 40% plus of the index,” he continued. “Three names represent 25 give or take% of the S&P 500: Nvidia, Microsoft and Apple. That is extraordinary concentration.”

In addition to protection from over-concentration, there are reasons to believe the equal-weighted index could outperform the cap-weighted index going forward.

For one, while the equal-weighted index’s recent performance has been relatively poor, it has actually outpaced the cap-weighted index by 1.05% on an average annual basis from 1989-2023, according to Invesco.

Smith also said that the equal-weighted index’s low valuations also make it an attractive buy. Its 12-month forward PE ratio is around 22, while the S&P 500 cap-weighted index’s is around 30. Invesco pointed out earlier this year that relative valuations between the two indexes are about as far apart as they have been in the last 20 years.

Finally, Smith argues that broadening economic growth — which has been largely supported by AI capital expenditures — would also benefit the equal-weighted index.

“If we’re correct on our economic outlook, stronger growth would support that broadening out,” Smith said. “And that would suggest that maybe over the next 6 to 9 months, you might see better relative performance from the equal-weighted S&P 500.”

Read the original article on Business Insider