A comparison of the S&P/TSX Composite and the equal-weighted S&P/TSX Index is, in some ways, the market equivalent to a doctor measuring blood pressure during a medical check-up. It's a simple measure that can quickly provide a general idea of health or indicate a whole host of problems to be assessed.
At the moment, the equal-weighted index implies a severe lack of market depth and the dramatic outperformance of large-cap stocks.
The most commonly followed domestic equity benchmark is the S&P/TSX Composite. It's market cap-weighted, which means that a small change in a large company stock has a much larger effect on the overall index than a far higher percentage stock move for a smaller company.
In the equal weighted index, all companies have the same influence on performance. A five per cent rise in Royal Bank of Canada stock, for instance, has the same effect as a five per cent change in Wajax Corp., a company with a market capitalization more than 200 times smaller than Royal Bank.
The chart below tracks the value of a hypothetical $10,000 investment in both the S&P/TSX Composite and the S&P/TSX Equal Weighted Index in October of 2011.
S&P/TSX Composite vs S&P/TSX Equal Weight Index: Value of $10,000 Invested
SOURCE: Scott Barlow/Bloomberg
From the start to April 2013, the indexes moved together. This suggests broad-based strength for the period – most stocks in the benchmark contributed to the upside. In a narrow market, where only a few stocks were driving market performance, the conventional market-cap weighted index would be outperforming the equal weighted benchmark.
The cap-weighted index began pulling away after the taper tantrum in May 2013. That's what happens when some market sectors stop pulling their weight. Even small-cap underperformers can pull down the performance of the equal weighted benchmark.
Since May 2013, the equal weighted index has underperformed by 14 per cent, a significant margin. This implies an increasingly narrow market – fewer and fewer large-cap stocks driving performance. It also suggests small-cap stocks are underperforming badly, a trend made more obvious by the brutal beatings endured by many junior oil stocks.
We can also draw inferences about investor risk tolerance from the underperformance of small caps. Investors' current avoidance of smaller companies highlights a declining tolerance for risk.
Narrow markets are fragile. As more stocks trail behind, it's like removing legs from a stool (or, for those old enough to remember, like a game of Kerplunk). Thankfully, there's no reason to believe that equal-weighted index won't begin to recover. But investors should be cautious on the market as a whole until it happens.
Follow Scott Barlow on Twitter @SBarlow_ROB.