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Jubak's Journal
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• As scandal shakes insurers, steer clear, 10/22/2004
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The stealth stock-market rally
The major indexes may be down, but their biases hide plenty of opportunity. Small and mid-caps look especially promising right now.
By Jim Jubak
In the last month, the Dow Jones Industrial Average dropped 3.8%. The Standard & Poors 500 declined 2.1%.
But Id argue that the stock market, unlike the indexes, is up over the last month despite surging oil prices, scandal in the financial industry, Vioxx-induced pain in the drug sector and the nervousness that comes with a very, very tight presidential election. All that leads me to conclude investors should be buying, rather than selling stocks (but only the right ones, of course) as we head to Election Day.
So how can the major indexes be down and stocks still be up? Glad you asked.
Beware index biases
To begin with, major indexes like the Dow Jones Industrial Average ($INDU) and S&P 500 ($INX) are tilted toward big-company stocks. The 30 Dow stocks include names such as Microsoft (MSFT, news, msgs) with a market capitalization of $310 billion, General Electric (GE, news, msgs) with a market capitalization of $352 billion and Exxon Mobil (XOM, news, msgs) with a market capitalization of $318 billion. In this company McDonalds (MCD, news, msgs), with a market capitalization of $36 billion, looks small.
The S&P captures more stocks, 500 to the Dows 30, but it is still tilted toward big companies. Together those 500 companies have a market capitalization equal to 80% of the total market capitalization of all the stocks traded on the New York Stock Exchange. With 2,747 stocks listed on the NYSE, you can see that the 500 S&P stocks each have to be pretty hefty to make those numbers work.
But the tilt toward bigness doesnt stop there. The Dow is weighted by share price. So a move in a high-priced stock such as American International Group (AIG, news, msgs), at $56.45 on Oct. 21, counts for about twice as much as the move on a lower-priced stock such as McDonalds at $28.52. And, of course, AIG counted for even more in the Dow when it traded at $72.61 on Sept. 7.
The S&P index is weighted by market cap rather than share price. So a move in a company with a huge market cap has proportionately more influence on the index than a move in a company with a low market cap. So, for example, Pfizer (PFE, news, msgs)s 20% drop this year counts for a lot more than Parametric Technology (PMTC, news, msgs)s 27% gain so far in 2004 -- because Parametric has the ninth-lowest market cap in the index at just $1.3 billion while Pfizer has the sixth-highest market cap in the S&P 500 at $212 billion.
Adjusting for size bias
What would the performance report card for stocks look like if we took out a good part of the tilt toward bigness?
We can get part of the answer by taking a look at the Value Line Composite Index of the 1,700 or so stocks tracked by the Value Line Investment Survey. (You can find more on the index at Value Lines Web site.) Unlike the capitalization- or price-weighted indexes, the Value Line Composite is weighted so that a 10% gain or loss in any stock moves the index equally.
For the last month, when the Dow stocks were down 3.8% and the S&P 500 down 2%, the Value Line Composite was just about flat, down 0.6%. Go back six months and the difference gets pretty dramatic: The Dow industrials are down 5.8% for that period, the S&P 500 down 3% and the Value Line Composite down just 1.7%. (Ive used the Value Line Composite Arithmetic Index in all these calculations.)
Down is still down, true enough. But look at what happens when you go a step further and dont just attempt to remove the size bias but actually try to reverse it. Year-to-date the S&P 500, the big-cap index, is down 0.5%. But the mid-size company index, the Standard & Poors MidCap 400 ($IDX), was up 2.8%. And the small-company index, the Standard & Poors Small Cap 600 ($XSM.X), was up 8.2%.
My conclusion: Once you correct for size, stocks are doing better than the most-watched indexes show. And if you look at just mid-size and small-company stocks, the market has actually been moving up, even during a period when the major indexes are down.
More evidence of a stealth rally
Now, I always like to double-check a conclusion like that before I put some money behind it. Im just as liable as anyone else to torture the data until it gives up the patterns I want to see. In this case, a good cross-check is the Advance/Decline Line, which is determined by taking the difference between the number of stocks that have advanced that day and the number that have declined and then adding or subtracting the difference from the cumulative Advance/Decline Line. When more stocks are going up than falling, the Advance/Decline line climbs; when more are declining than climbing, the Advance/Decline Line falls.
Right now, the Advance/Decline Line is near a multiyear high and above the high for 2004 set on March 5. Thats a sign of a rising market that is trending higher.
The read from this technical indicator, according to Dan Sullivan, editor of The Chartist, is confirmed by the high/low differential, the 10-day moving average of new highs versus new lows. That indicator is near its six-month high.
Why the big indexes are missing out
I also like to double-check my double-check by seeing if I can understand the logic to the data. In this case, Id like to know why the most-watched indexes with their tilt toward big-company stocks might be missing the strength of the overall market.
Its not too hard to figure out why the Dow might be underperforming the overall market this year. The index is chock-full of stocks that are having truly bad years, such as Merck (MRK, news, msgs), down 32% year to date; Intel (INTC, news, msgs), down 31%; AIG, down 15%; Hewlett-Packard (HPQ, news, msgs), down 14%; Pfizer, down 12%; Coca-Cola (KO, news, msgs), down 12% and General Motors (GM, news, msgs), down 11%. This year, the index over-represents the problems in the drug, technology and insurance sectors.
The S&P 500 has the same problem if you look at the sector breakdown of the index. For example, the energy sector of the S&P 500 has done extremely well this year, rising 25% for 2004 to date, according to Standard & Poors. But the energy sector makes up 7.4% of the total S&P 500. Sectors such as financials (20.6% of the S&P 500), information technology (15.7%) and health care (13%) are all more heavily weighted than energy stocks in the index. And those sectors, rather than climbing this year, are down 2.5%, 6.1% and 9.6%, respectively.
Calls to action
What does all this add up to? Two conclusions that lead to calls to action.- The stock market is far stronger than the indexes show in a period of historical weakness. Given all the truly negative forces acting on this market, I think that strength is very, very positive. Theres a good chance that the potential end-of-year rally will materialize after Election Day. Not all of the Yes, buts I listed in my Oct. 15 column, Will the year-end rally survive October? have been settled in favor of Yes, certainly. But the signs are encouraging. For example, the Nasdaq Composite Index ($COMPX) has continued to outperform the Dow and it has held above support at 1,900; the issue for this index has shifted from a question of will it hold support? to can it break through resistance at 1,940 and 1,950? Among my bellwether technology stocks, Broadcom (BRCM, news, msgs) issued disappointing earnings numbers, but the news from the rest of the sector leaders has been good enough in my judgment. The risk/reward ratio has shifted enough so that its time to add to equity positions for a year-end rally.
- The rally, when it becomes visible, is likely to favor the same kind of stocks that have done well in the stealth rally this year. That means mid- and small caps. Given the greater volatility in small-cap stocks against their slightly larger mid-cap brethren -- and the uncertainties that still surround a year-end rally -- Id favor mid-caps over small caps at this point. What specific mid-cap stocks? Id look for stocks with solid, improving relative-strength rankings over the last three months (showing theyve been stronger than the general market) and those that have announced earnings surprises this quarter. Its too early to screen for such stocks because were only part way through earnings season, but Ive come up with five companies that have already reported earnings and that fit the bill: Citrix Systems (CTXS, news, msgs), Diamond Offshore Drilling (DO, news, msgs), Paccar (PCAR, news, msgs), QLogic (QLGC, news, msgs) and Wipro (WIT, news, msgs).
Keep your eyes open for more as other companies report during the coming days. Ill report on any that I find in the updates section of this column.
New developments on past columns
As scandal shakes insurers, steer clear
Some reader e-mail on this story provided or asked for some important clarification. First, one reader took issue with my back-of-the-envelope accounting of how much of the contingent commissions Marsh & McLennan (MMC, news, msgs) collected from insurers dropped to the bottom line. I noted that the $845 million the company took in from this source was likely to be almost pure profit and thus could have made up almost half of the companys net income for the year. Wrong! As this reader, Doug Famigletti of Griffin Asset Management noted, I was comparing pre-tax apples with post-tax oranges because the $845 million was all pre-tax, but Marsh & McLennans net income was post-tax. A more likely figure, Famigletti wrote, would be one-third and not one-half. Second, a number of readers asked why I hadnt mentioned Jubaks Picks selection Berkshire Hathaway (BRK.B, news, msgs) in this column. To the best of my knowledge, Berkshire Hathaway sells its auto and re-insurance policies without using brokers. That would put them outside the scope of the New York Attorney Generals investigation.
Will the year-end rally survive October?
A number of readers, including my editor, as a matter of fact, asked why I hadnt added the effects of a Kerry or Bush victory on the stock market to my list of Yes, but factors. First, data on whether the market does better under a Democrat or a Republican is nowhere near as clear cut as partisans of either party would have us believe. You can torture the very few meaningful data points we have to produce pretty much any result you want. Much more significant to me in the current situation is the possibility of a 2000-sytle electoral deadlock. That possibility is remote, I believe. (For more on the scenarios that could produce electoral chaos see Richard Hasens Oct. 18 piece on Slate.com, Florida 2000: The Sequel. But even that remote possibility hangs over Wall Street at the moment and is keeping some money on the sidelines. Because a disputed election would certainly not be good for stocks, the thinking goes, why not wait until the votes are counted (and recounted) before investing? Worry about low-probability events such as this can put a lid on the financial markets. History shows, however, that if the unlikely event doesnt happen, the markets usually respond with a relief rally. Now, if we only knew not how the election will come out, but that the election will come out.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: American International Group and Microsoft. He does not own short positions in any stock mentioned in this column.
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