Investors should fade small and mid-cap (SMID) stocks and mega-cap stocks, and instead focus on the equal-weighted S&P 500 (SPW), according to Bank of America strategists.

In a note published Wednesday, the Wall Street bank highlighted SPW as a compelling alternative, trading on favorable valuation and improved fundamentals relative to both the mega-caps and the Russell 2000 (RTY).

The S&P 500 has posted a 12% gain year-to-date, with 10 percentage points of this return attributed to upward revisions in earnings expectations. Despite this, the strategists point out that much of the market's gains have been concentrated in a handful of megacap stocks, often referred to as the "Magnificent 7."

Excluding these, the S&P 493 is now on track to grow earnings by 8% year-over-year in the second quarter, marking its first quarter of earnings growth since Q4 2022.

Meanwhile, small-cap stocks remain in an earnings recession that began in Q4 2022, with the S&P 600 showing an 11% year-over-year decline in earnings so far in Q2.

BofA notes that “rising recession concerns hit small caps harder if history is a guide.”

“Investors looking to diversify beyond mega-caps should look to the equal weighted S&P 500 (SPW) on improving fundamentals vs. the Russell 2000 (RTY) which is still in the red. And valuations for the SPW are also compelling,” they added.

Notably, the equal-weighted S&P 500 is currently trading at an “extreme discount” to the cap-weighted S&P 500, nearing levels last seen during the Tech Bubble, strategists highlight.

Although it is 8% more expensive than the Russell 2000, they argue that this premium is justified by the equal-weighted index's lower risk profile and the potential for higher returns based on the current equity risk premium.

The SPW offers a lower beta (0.9) compared to the cap-weighted S&P 500 and the Russell 2000, which have betas of 1 and 1.1, respectively. Betas measure the volatility or systematic risk of a stock or index relative to the overall market. For instance, a beta less than 1 suggests the asset is less volatile than the market.

“Based on the current equity risk premium, the equal-weighted S&P 500 should trade at a premium to the S&P 500 and should trade at a 12% premium to the Russell 2000, all else equal,” strategists concluded.

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