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Issue No. 64 – January 30, 2006 Prescott, Arizona Systems@WiserTrader.com
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1.0 Trading
Major indices are making another run toward the upper band of a 2-year rising wedge.
1.1 Another Run
After falling back into a 2-year rising wedge pattern, the major indices have once again risen above resistance and this time with more impressive volume. Recent performance is illustrated by the NYSE Composite Index in Figure 1.
FIGURE 1
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1.2 Major Indices
From a macro view, the major indices appear to reflect similar behavior. In spite of this similarity, they have important differences in their makeup and the way they are calculated.
The Dow Jones Industrial Average (DJIA) has been based on only 30 stocks since 1928. Currently, the decision concerning which stocks are to be included in the DOW 30 is based on the subjective judgment of the Wall Street Journal managing editor & index editor. In general, the DOW 30 stocks are intended to include the largest & most well-established ("Blue Chip") publicly-traded Industrial (meaning not Transportation or Utility) companies in America. Stocks in the DJIA account for just less than 30% of total American equity capitalization. Unlike other stock market indices, the DOW is not weighted by market capitalization (price multiplied by the number of shares outstanding). Originally, Charles Dow simply added-up the prices and divided by the number of stocks to get an average. To preserve historical continuity, the divisor has been continually adjusted -- most frequently to account for stock splits. As an example, consider an averaged index composed of three stocks selling at $5, $10 and $15. The average price of these stocks would be $10. But if the $15 stock split 3-for-1, the average stock price would suddenly become $6.67. By changing the divisor from 3 to 2 to correct for the split, the average remains $10. Over the years the divisor has become smaller and smaller, falling below 1 in 1986 following a 2-for-1 stock split by Merck. Dividing by a number less than one is multiplication.
To find the current DOW divisor, divide the DJIA by the sum of the prices of the stocks. On Monday, November 15, 2004 the divisor became 0.13532775 -- meaning each $1 change in a DOW stock price caused a nearly 7.4-point change in the DJIA. The fact that the DOW is a price-average index means that high-priced stocks have a bigger impact on the index. A 10% move in a $100 stock has 5 times the effect of a 10% in a $20 stock. The greater "weighting" of the high-priced stocks in the DOW has a similar effect as the weighing by market capitalization for other indices.
The NYSE Composite Index in Figure 1 reflects the behavior of 2,049 common stocks. The NYSE Composite Index -- comprised of all the stocks listed in the New York Stock Exchange -- would seemingly be more representative of market activity for America's most established companies, but it is not widely watched. The main reason that the DOW is the most popular index is because it has been watched & quoted for so many years. The DOW undoubtedly exerts a disproportionate impact on investor psychology.
The NASDAQ Composite Index is a market capitalization weighting of prices for all the stocks listed in the NASDAQ Stock Market. Market capitalization is price per share of stock times the number of shares outstanding. In contrast to the S&P 500 which has about a quarter of its market cap in technology, two-thirds of the NASDAQ Composite market cap is computers, software and telecommunications (telecom) companies. In contrast to the NYSE, the NASDAQ Stock Market does not require profitability as a requirement for listing.
The S&P 500 Index is intended to represent the 500 biggest publicly traded companies in the United States by market capitalization (in contrast to the FORTUNE 500, which lists the largest 500 companies in terms of sales revenue). Although the general principle for calculating the S&P 500 Index based on market capitalization of the largest 500 companies is simple, the details can be complex. The S&P 500 Index comprises about three-quarters of total American capitalization. In 2001, forty of the S&P 500 stocks provided half of the Index's total market cap. In 1999, nine of the S&P 500 stocks provided half of the Index's total return. So this index can also be skewed by a disproportionately small number of companies.
There are both objective & subjective standards for inclusion in the S&P 500 Index. To be included a company must be profitable. The prospective company must not be closely held (at least 50% of its stock should be public) and must have a large trading volume for its shares. Although over a tenth of the companies listed on the NYSE are foreign (listed as an ADR, with underlying shares held overseas), these are excluded from the S&P 500. Companies are usually removed from the Index due to mergers, acquisitions, bankruptcy or a significant drop in market cap.
The subjective criteria are based on a committee that meets monthly in New York City to review the stocks comprising the S&P 500. The meetings are held in secret and minutes are not released to the public. Inclusion or exclusion of a stock from the Index can have a dramatic effect on stock price because Index Funds typically buy more than 5% of a newly listed company's outstanding shares between the announced inclusion and the inclusion. Companies removed from the S&P 500 suffer an average 12% loss between the announcement of removal and the removal but these losses mostly vanish within six months. In the late 1990s the S&P 500 committee showed a distinct bias toward the inclusion of technology stocks, to reflect their "up-to-date" attunement with the "New Economy" -- bringing tech stocks to roughly a quarter of the S&P 500 total value. Price/Earnings ratios (P/Es) were not a factor in making these inclusions, which resulted in the S&P 500s P/E average rising well above historic levels.
The Russell 2000 Index comprises the 2,000 smallest companies in the Russell 3000 Index, representing about 8% of the Russell 3000 market cap. The Russell 3000 Index represents about 98% of the total market cap of all American domiciled corporations. Unlike the Wilshire 5000 Index which attempts to include all the (more than 5,000) shares of publicly-traded companies, the Russell 3000 focuses on 3,000 frequently-traded stocks as a way of creating a more accurate and readily-updated index. The Russell 3000 is divided into the Russell 1000 and the Russell 2000. The Russell 1000 Index comprises the largest 1,000 companies in the Russell 3000, representing about 92% of the Russell 3000 market cap.
Despite the large number of stocks in the Russell 2000, the Index is no less vulnerable to a disproportionate influence from a few exceptional performers. In the June 30, 1999 to February 11, 2000 period the Russell 2000 advanced 17%, half of which was due to only 13 stocks. The Russell 2000 Index is far more widely watched & used than the Russell 3000 or Russell 1000. The Russell 2000 Index is widely accepted as representing the "small cap" portion of the US stock market.
Most money managers treat the S&P 500 as a proxy for the US stock market. Although the market is better represented by the NYSE Composite, the Wilshire 5000 or the Russell 3000, one has to watch the S&P 500, as well as the DOW and NASDAQ, in order to understand the behavior of large investors. Divergences between these indices are common but usually small and short term. The more volatile Russell 2000 and NASDAQ typically point the direction for the broader and higher capitalization indices in a healthy market. To read more, see The Major American Equity Indices by Ben Best.
2.0 Market Analysis
Sentiment improved dramatically this week as the market rose, ignoring a low 1.1% fourth quarter GDP growth rate. Expectations are that a lower growth rate may spur the Fed to end rate tightening sooner. General bullishness across all sectors, except biotech and utilities, will eventually reveal leaders and laggards.
Key industry ETF’s in Table 2A are Biotech and Semiconductors, which confirm the NASDAQ. Transportation confirms the Dow Jones Industrial Average according to Dow Theory. Banking and Financials are confirming indicators for the S&P 500. Gold and Real Estate are respective indicators for the inverse health of the currency (inflation) and the capacity for consumer spending.
Table 2A
Indices, Key Industry ETF’s and Sector SPDR’s
|
|
1 month |
1 wk ago |
2 wks ago |
3 wks ago |
4 wks ago |
|
Dow Jones Industrial Index |
1.8% |
2.2% |
-2.7% |
0.0% |
2.3% |
|
NASDAQ Composite Index |
4.5% |
2.5% |
-3.0% |
0.5% |
4.5% |
|
NYSE Composite Index |
2.8% |
1.8% |
-2.0% |
0.2% |
3.0% |
|
S & P 500 Index |
4.4% |
2.5% |
-1.5% |
-0.1% |
3.6% |
|
Russell 2000 Index |
8.8% |
3.9% |
-0.5% |
1.3% |
3.9% |
|
GLD, GOLD |
7.9% |
0.8% |
-0.4% |
3.2% |
4.1% |
|
RKH, Banking |
1.4% |
3.5% |
-3.5% |
-0.7% |
2.2% |
|
IYT, Transportation |
2.2% |
3.8% |
0.0% |
-1.7% |
0.2% |
|
SMH, Semiconductors |
4.3% |
2.2% |
-5.2% |
-0.5% |
8.2% |
|
BBH, Biotechnology |
-3.0% |
-0.5% |
-1.6% |
-1.4% |
0.5% |
|
IYR, Real Estate |
7.4% |
3.0% |
-0.3% |
-0.1% |
4.8% |
|
OIH, Oil |
18.7% |
0.8% |
6.6% |
1.7% |
8.7% |
|
XLE, Energy |
12.6% |
0.4% |
3.6% |
1.9% |
6.3% |
|
XLU, Utilities |
3.1% |
-1.0% |
1.6% |
0.1% |
2.5% |
|
XLB, Materials |
4.4% |
4.9% |
-1.5% |
-2.6% |
3.7% |
|
XLI, Industrial |
0.6% |
2.1% |
-2.1% |
-0.5% |
1.1% |
|
XLK, Technology |
3.9% |
2.1% |
-3.9% |
0.6% |
5.3% |
|
XLV, Healthcare |
1.8% |
1.0% |
-1.5% |
-0.3% |
2.6% |
|
XLF, Financials |
1.6% |
2.7% |
-3.7% |
0.2% |
2.5% |
|
XLP, Consumer Staples |
1.0% |
1.6% |
-1.3% |
-0.1% |
0.9% |
|
XLY, Consumer Discretionary |
2.4% |
1.5% |
-1.8% |
0.7% |
2.1% |
