The Tribune Democrat, Johnstown, PA

May 4, 2013

NICK MASSEY | Beware of stock indexes

Nick Massey
The Edmond (Okla.) Sun

— One of the basic rules of military strategy is that when aggressively pursuing the enemy, you have to be sure you don’t outrun your supply lines. If the guys bringing the food, ammo and fuel can’t keep up, it doesn’t take long before bad things happen.

There is a similar analogy with the stock market. One has to ask, how much longer can the Dow and the S&P 500 continue to outrun the rest of the market? There is an old story about a potentially ominous situation when the blue chip stocks continue to make new highs while the rest of the market has possibly topped out or is in some degree of correction.

The story suggests that when the generals leading the advance up the hill eventually look over their shoulders and see the troops in full retreat, they soon have to join the retreat.

At the risk of being the skunk at the party, I have to ask, how much longer can the blue chips (the generals) pretend that everything remains positive for the economy and supportive of higher stock prices when the broad market (the soldiers) and the transportation index (the supply guys) are not?

Does it matter that new- home sales fell 4.6 percent in February – the biggest decline in two years? Or that durable goods orders without aircraft orders fell 2.7 percent in February? Or that consumer confidence fell from 68.0 to 59.7 in March? Or that consumer sentiment plunged from 79.3 to 72.3 in April (a nine-month low).

Have you noticed in the past few months, a divergence between a rising stock market and declining commodity prices? This is a potentially ominous sign for the economy and stock market going forward. A six-year chart of the CRB Index of Commodity Prices shows declining commodity prices usually indicate demand for goods is dropping and the economy is in trouble.

Meanwhile, much has been written about the market being back to old highs and making new ones. But there is more to that story than meets the eye. Maybe the index is back, but not all stocks. Specifically, have the portfolios of buy and hold investors even come close to coming back?

The market has finally rallied back to the levels of its previous peaks of 2000 and 2007. That allows Wall Street to revive its longtime mantra in support of “buy & hold” investing as a viable strategy and that “the market always comes back.” The claim is based on the fact that the market indexes eventually come back, although it sometimes takes 15 to 20 years, as in the 1930s and 1970s. But does that mean buy and hold investors’ portfolios have come back?

Not at all. The stocks that make up the indexes are periodically changed so significantly as to make the market that comes back entirely different than the market that went away.

For instance, 23 percent of the stocks that were in the Dow in 1999 were no longer in that index just five years later. They had been replaced by stronger companies that were more representative of the changing economy.

Don’t get me wrong. This is necessary. The indexes were developed to closely represent the U.S. economy at any given time. Previously dominant companies that lose their importance in the economy

are replaced by the newly

dominant companies. So a Sears is replaced by a Home Depot, a Kodak by Pfizer, and so on.

In just the seven years from 1999 and 2006 there were 109 changes in the stocks that comprise the Nasdaq 100, an index that contains only 100 stocks

Obviously, the fact that the indexes come back has little relevance in some cases with stocks.

You have to wonder which popular stocks currently in the indexes won’t be there the next time the market declines and investors wait for them to come back.

Even many of the stocks that do remain in the indexes do not necessarily come back.  The Dow has come back to its previous peak, but of the 30 stocks in the Dow, 11 (more than 30 percent) are still down an average of 61.2 percent from their levels of 2000.

As for whether blue chip stocks are set to fall or the

others are set to catch up,

could it be that the Dow is correct and all the others are wrong? Perhaps. However, there is certainly a case for being cautious now. Keep your eyes on the generals. To borrow an old phrase from the bomb squad personnel, “If you see them running, try to keep up.”



Nick Massey is a columnist for The Edmond (Okla.) Sun.

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