Here’s the Shocking Reason for the S&P 500’s Strong Gains

When it comes to stock market participants, day traders and index investors are the on opposite ends of the spectrum. The first group conjures images of boiler rooms full of traders scanning multiple computer screens, looking for short-term price movements to quickly profit.

Index investors, on the other hand, are not interested in day-to-day price gyrations and other market minutiae. They understand in the long run it’s nearly impossible to beat the stock market by excessively trading and are willing to accept the broader market’s returns to fund their retirement.

It might appear these two groups have nothing in common, but both surprisingly benefit from a common investment strategy: momentum. Here’s what you need to know about how momentum factors into your index and why it’s helped power the S&P 500 and Dow Jones Industrial Average higher.

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Momentum or contrarian?

There are many investment strategies, but they all boil down to two broad approaches: contrarian and momentum.

Momentum assumes the broader stock market is right and stocks that have shown a recent pattern of upward (or downward) movement will continue their trajectory. To summarize a common momentum aphorism, “the trend is your friend.” Momentum investing is often associated with growth investing, as the market tends to reward stocks with a strong track record of growth.

Contrarian approaches assume the opposite: Investors fundamentally misunderstand a stock and, as a result, its price is below its true value — or a stock has unwarranted positive sentiment and is bound to fall back to earth when sanity resumes. The contrarian approach is associated with value investing, with the most famous adherent being Berkshire Hathaway CEO Warren Buffett.

If you own ETFs that track broader U.S. indexes, you are likely taking advantage of the momentum strategy. To understand how, you must know how the underlying index is constructed. As you’ll see below, some weighting systems are more conducive to momentum investing than others.

What’s your weight?

Broadly, there are three approaches to weighting an index:

• Equal Weighted: Each stock equally affects the overall return; if half the stocks in the index increased by 1% and the other half decreased by 1%, the equal-weight index would provide no return. Compared to others, equal-weighted indexes better reflect smaller companies and lower share prices and lean toward a value style as gainers are sold off to buy underperformers. Equal weighting is difficult, as these indexes require constant rebalancing and as a result are not often reflected in broad stock market indexes.
• Price Weighted: Price weighting is conceptually easier to understand, as it would provide the same returns as if you purchased one share of every stock in the index. In a price-weighted index, stocks with higher share prices affect the index more than those with lower share prices. Rebalancing is not often needed unless companies split…