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This chart shows the ratio of S&P MidCap 400's PE ratio to S&P 500's PE:

https://www.rbcwealthmanagement.com/_assets/images...

This relative valuation can be taken advantage of by either moving funds from a cap weighted index such as SPY to an equal weighted such as RSP, or alternatively purchasing a mid cap index such as MDY. In either case you are dramatically (or completely) reducing exposure to the large cap firms. If you are holding QQQ, it would be an especially good time now to change it to QQQE.

- Manlobbi

Baltassar wrote from the Berkshire board:
For myself, I would not consider SPY or QQQ as LTBH choices from where we are at the moment.

I agree. I would replace these two market cap weighted index ETFs with equal weight versions; replace QQQ with QQQE and replace SPY with RSP. As a variant to the equal weight index RSP, you could alternatively use a mid-cap S&P500 ETF such as SPMD, as the returns were, and will be, extremely similar between mid-cap and equal-weight. We just want to avoid the large-cap weighted index right now.

The reasons:
1. Over the long term, even starting from an average valuation for all indexes, the equal weight (and likewise the mid-cap) index outperformed the market cap weighted index by about 1.5% per year after expenses.
2. To make matters worse, we are not starting from an average valuation for both indexes. The market cap is particularly expensive relative to equal-weight (or mid-cap) *right now* and this is reflected in the equal weight index not having outperformed, to its longer 100 years+ historical level of about 1.5% per years, over the last 20 years. So I expect the forward 20-year return from here to favour the mid-cap over the S&P500 even more than 1.5% than it did historically. The following chart shows the ratio of S&P MidCap 400 price-to-earnings, to the S&P500 price-to-earnings:
https://www.rbcwealthmanagement.com/en-asia/wp-con...

It is a bad time to enter the S&P500, relative to a mid-cap, or equal weight variant, right now.

- Manlobbi

Manlobbi,

Thank you. All great points and very interesting chart. I have a pretty large SPY position but unfortunately it is in a taxable account so I’m less eager to reposition to an equal weight ETF. Jim seemed to like QQQE better than RSP based on his data. Are you in agreement with this conclusion for the long-term?

Also, do you have any concerns about the growing influence of passive market cap funds and their huge growing flows creating an “artificial” advantage based on their influence and size alone vs. equal weight? Excerpt from CNBC piece linked below.

“They have argued that index ownership concentrates into a small handful of firms (BlackRock, Vanguard, State Street, etc.) that can have outsized influence on the markets. Some have argued that because stocks are indexed by market capitalization, passive indexing will push money into the largest firms, regardless of whether the companies are performing well.”

https://www.cnbc.com/2023/02/22/growth-of-etfs-and...

I can't speak for Manlobi, but I have never understood the idea that firms managing index mutual funds have "outsize influence." How is such influence exercised, and to what end?

As to the claim that cap weighted indexing is influential per se, insofar as it pushes money toward larger companies, I can see that being true on the margin; but maybe not. If mutual funds were outlawed, my guess would be that big companies would be more, rather than less, able to attract disproportionate investment. The "nifty fifty" long antedated the widespread use of indexing. I speak in total ignorance, but I would not be surprised if indexing has increased, rather than decreased, the diversity of the average portfolio.

Baltassar

Hi Manlobbi,

You wrote, in the OP of this thread:
"
This chart shows the ratio of S&P MidCap 400's PE ratio to S&P 500's PE:

https://www.rbcwealthmanagement.com/_assets/images...

This relative valuation can be taken advantage of by either moving funds from a cap weighted index such as SPY to an equal weighted such as RSP, or alternatively purchasing a mid cap index such as MDY. In either case you are dramatically (or completely) reducing exposure to the large cap firms. If you are holding QQQ, it would be an especially good time now to change it to QQQE.
"

Sadly, it appears the image is no longer available there, but I found the article at RBC: https://www.rbcwealthmanagement.com/en-asia/insigh...

It shows the charts that compare both small cap and mid cap PE ratios to that of the S&P 500, and, when written in Jan 2023, both small and mid cap indexes were significantly lower PE compared to the S&P than average. At that time the ratios of their PEs to S&P500 PE were about .8 vs average of ~1.1-1.2.

Since January 1 2023, the S&P 500 has outperformed the S&P 600 small cap index substantially, gaining ~22% vs ~12% for Small Cap or ~14% for Mid Cap, so the valuation gap has widened, if we assume longer term forward prospects for those collections of companies are the same as they were.

I've been building up my allocation to Small Cap Value (SCV), through the Dimensional Funds Small Cap Value ETF DFSV. I believe the academic research identifying SCV as a typically out-performing sector of the stock market is backed up by both past results and tenants of behavioral psychology, i.e. people want to buy and own stocks of companies they know (typically large cap) and which have been performing great (typically growth), so those stocks tend to be highly valued. The inverse, small-cap value, tends to be less popular, hence less highly valued, and so outperforms, on average.

I know some prominent investors/posters here dismiss that reasoning, but it rings true to me, and I wish I'd stuck to my SCV-heavy portfolio of mostly index funds + Berkshire instead of wandering off into the bushes seeking value in individual stocks where, to be frank, I don't have a good record of returns, overall.

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