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Divergences between SPY and RSP

The SPX market-weight ETF (SPY) and the SPX equal-weight ETF (RSP) track the same index (SPX). Although both consist of the same SPX companies, they can trade differently.

The difference between SPY and RSP is former is influenced heavily by the most significant market cap components. While the latter are equal in weight and impact.

As the name implies, every stock in an equal-weighted ETF has the same weight, regardless of the size. The most influential component of the SPX by market cap (APPL) has the same weight as the smallest.

Since mid-size and smaller companies have the same influence on the index as larger-cap companies, it creates a more equitable, balanced, and diversified portfolio.

The equal-weight index also can reduce concentration risks by spreading the risks evenly across the index, allowing investors to have representation to a wide selection of businesses in numerous sectors and industries.

An equal-weight index is another way to measure the internal health of the underlying index or market breadth. Not favoring larger-cap companies can provide a better and more accurate picture of the entire market.

However, investors must recognize that equal-weight indexes can underperform the market-cap weight indexes when mega-cap stocks control the marketplace.

Also, during devastating bear market declines, investors tend to favor the safety of larger-cap names, at least from a relative strength perspective. An equal-weight index with large concentrations of smaller-cap and illiquid companies may be vulnerable to sharp swings during market selloffs.

Equal-weight indexes are popular for investors looking for diversification and higher returns. Although equal-weight indexes have outperformed market-weight indexes over the long term, they are also more volatile, especially during bear markets.

Most of the time, the equal-weight RSP and the market-cap weight SPY will trade together, trending up or down in the general direction. Any prolonged divergences between the two markets warn of a trend reversal.

A brief review of the RSP and SPY since December 2022 shows divergences between the two ETFs.

For instance, a series of lower highs have developed in RSP, including 2/2/23 at 154.93, 4/1823 at 146.21, and 5/1/23 at 145.83 versus a flat-trend for SPY, including 2/2/23 at 416.72, 4/1823 at 415.72, and 5/1/23 at 517.62.

Also, lower lows are visible in RSP (i.e., 12/22/22 at 137.32, 3/15/23 at 135.99, and 3/24/23 at 135.79) versus higher lows for SPY (i.e., 12/22/22 at 373.34 and 3/13/23 at 379.20).

On a shorter-term basis, a minor divergence has also developed between the two ETFs. Since late-Apr 2023, RSP shows a lower-low pattern (i.e., 4/26/23 at 140/94 and 5/4/23 at 140.16.). On the other hand, SPY shows a flat trend (i.e., 4/26/23 at 403.78 and 5/4/23 at 403.74). If this trend continues, it suggests a lack of broad market participation.

The dramatic outperformance from the larger-cap SPX technology names (i.e., AAPL, MSFT, GOOGL, NVDA, etc.) and larger-cap defensive sectors (XLV and XLP) may explain the bulk of the divergences.

Nonetheless, seasonal factors still favor technology and growth-related areas into early summer. It is reasonable to expect SPY to break out above 416.72-417.62 (2/2 and 5/1/23 highs). A breakout suggests 13.88 points, rendering a SPY target as high as 431.5 into the summer months.

However, if the rally does not expand beyond the mega-cap SPX technology, healthcare, and consumer staples names or if the mega-cap SPX names enter into sharp selloffs, this will increase the odds for a stock market correction.

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