S&P 500, Dow Jones and Nasdaq – The Deceptive Intricacies of Popular Stock Market Indexes

On first glance the performance of the Dow Diamonds (DIA), S&P 500 SPDR (SPY) and Nasdaq QQQ (QQQ) seems to be closely correlated. This first glance assessment, however, couldn’t be farther from the truth. Here’s what separates the indexes from each other and why it’s important.

Index investing or ETF index investing is a popular and low-cost way to put your dollars to work, it’s like putting your portfolio on cruise control.

But driving on cruise control isn’t always the best way to get from A to B and doesn’t mean you won’t get into an accident. It merely means that you delegate speed control to your car.

Your level of commitment to your own portfolio ultimately dictates your style of investing: buy and hold via indexes or ETFs, buy and hold via actively managed mutual funds, or a more active approach to buying and selling.

Regardless of what type of investor you are, you need to be familiar with your investment vehicle(s) of choice, just like a driver needs to know the difference between automatic and stick shift.

Look Under the Hood

The S&P 500, Dow Jones, and Nasdaq are the most popular U.S. indexes and if you are an investor, odds are some of your money is invested in one or more of those three indexes.

Equity indexes are often described as a basket of stocks. Retirees or near retirees are familiar with the term nest egg and the comforting picture of many golden eggs nested up to provide a comfortable retirement.

But what if the basket of eggs is made up of one or two giant ostrich eggs that limit the space for other eggs? That wouldn’t be well diversified and one knock against the basket could scramble most of the retirement.

Hidden Ostrich Eggs

Financial ostrich eggs among major U.S. indexes are more common than you think.

IBM accounts for nearly 12% of the Dow Jones Industrial Average (DJIA or Dow Jones). Technically speaking, the DJIA is an average not an index. The DJIA is price weighted, in other words only the price of a stock matters, nothing else.

IBM is the most expensive stock of the DJIA and moves the index (or average) 20x more than Bank of America (BAC) even though IBM has only about twice the market capitalization (the price per share multiplied by the amount of outstanding shares) of BAC.

The ETF that best represents the DJIA is the SPDR Dow Jones Industrial Average ETF. Its ticker is DIA, that’s why it has the nickname Dow Diamonds ETF.

The Nasdaq-100 and the PowerShares Nasdaq QQQ ETF (QQQ) hide another “ostrich egg,” – Apple. Apple accounts for a whopping 20% of the Nasdaq-100 Index. If you already own Apple or don’t believe Apple is the way to play technology, you may not want to own QQQ.

The S&P 500 Index – represented by the S&P 500 SPDR (SPY) – provides more balanced diversification than the DJIA or Nasdaq-100. Apple, still the biggest player of the S&P 500, accounts for less than 5%. IBM has a weight of only 1.8%.

Considering the different composition of the three indexes, it’s remarkable how closely their day-to-day moves correlate.

The chart below provides a visual of the long-term correlation between the Dow Diamonds (DIA), S&P SPDR (SPY), and QQQs. Illustrated is the percentage change since April 1999 (when the QQQs began trading) to provide an apples to apples comparison of the three indexes.

The SPY and QQQ delivered a near identical return (+38%). The DIA is up 68% since April 1999. Of course the picture looks much different if you start measuring the return from the 2000 highs.

All three indexes and index ETFs share the commonality of having had very sizeable swings ranging from -60% to +60%. The Profit Radar Report advocates an investment approach that capitalizes on larger up moves and turns neutral or short during major down moves.

This approach can significantly enhance your return and reduce your exposure to risk.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.

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S&P 500 vs. Investors – Are Retail Investors Really the “Dumb Money?”

Retail investors have many choices to buy and sell stocks: Mutual funds and ETFs are just two of them. Regardless of the options, investors are often considered the “dumb money.” Is the dumb money really dumb?

Wall Street geniuses and the financial media often consider retail investors the “dumb money.” That’s ironic, because Wall Street and the media are notorious for dishing out group think advice that’s getting many of the small guys burned.

There’s plenty of data that shows that a plain index investing or index ETF investing approach (the real “dumb” buy and hold a basket of stocks approach) handily beats the returns achieved by Ivy League educated mutual fund managers that engage in actively buying and selling.

If you’ve read my articles before you know that I like to pick on Wall Street and the financial media, but today we’ll talk about the investing prowess of retail investors – the “dumb money.” Is the dumb money really dumb?

Is the Dumb Money Really Dumb?

One of the best measures of retail investor’s appetite for stock is the asset allocation poll conducted by the American Association for Individual Investors (AAII).

The chart below plots the S&P 500 Index (SPY) against investors’ portfolio allocation to stocks. Investors’ stock allocation pretty much waxes and wanes with the performance of the S&P and almost plots a mirror image of the S&P.

Unfortunately, the cliché is true; retail investors buy when stocks are high and sell when stocks are low. I believe this is due to crowd behavior and the forces of investing peer pressure rather than stupidity, as the term dumb money implies.

What else can we learn from this chart aside from the fact that retail investors tend to buy high and sell low?

The average allocation to stocks since the inception of the survey in 1987 is 60.9% (dashed red line). The S&P currently trades near a 52-month high, yet investors’ allocation to stocks is below average (60.5% as of August). This is unusual.

In fact, in the 21st century there’ve only been a couple of instances where investors’ stock allocation was below average when the S&P was near a 3+ year high. Those instances are marked with a red arrow. In August 2006 stocks went on to rally. In March 2012 stocks declined first and rallied later.

Lessons Learned

The lesson for investors is A) not to follow the crowd and B) not to follow Wall Street or the financial media.

The mission of the Profit Radar Report is to keep investors on the right side of the trade. A composition of indicators used identified the March 2009 and October 2011 lows as investable lows and got investors out of stocks at the 2010, 2011, and 2012 highs.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.

Will Small Cap Stocks Catch Up and Trigger a Buy Signal for the S&P 500?

“The stock market is doomed because small cap stocks are trailing behind the S&P” has been the financial media’s message. Obviously the market is doomed eventually, but for now this piece of Wall Street “wisdom” hasn’t paid off. Here’s what the Russell 2000 is telling us.

Small Cap stocks represented by the Russell 2000 and ETFs like the iShares Russell 2000 Index ETF (IWM) have received their fair share of media attention lately.

The focus has been on the under performance of the Russell 2000. This has been considered bearish for the S&P 500 (SPY), Dow Jones (DIA), and Nasdaq (QQQ) since small cap stocks are often viewed as a barometer for the market as a whole.

The Profit Radar Report has been promoting an individual and independant analysis of small caps, financials (XLF) and the Nasdaq to get a better read on the big picture.

Myth Buster

One detailed piece of analysis has shown that under performance by the Russell 2000 is not necessarily negative for the stock market.

There have been nine occasions over the last 20 years where the S&P was within 1% of a multi-month high (1,392 on July 30) while the Russell 2000 was more than 5% below a multi-month high (820 on July 5). This led to small negative returns only three times.

Above Resistance

Even though the whole lagging Russell doom scenario is busted, the Russell broke above key resistance. This happened on August 7, with a close above 800 (a day before XLF broke above resistance at 14.85).

Although the Russell was still lagging the S&P, this break was important and signaled more gains for small caps (financials) and the overall market.

The chart below plots the S&P 500 (SPY) against the Russell 2000 (IWM) and reveals divergences at various degrees.

In May 2011 the Russell 2000 Index recorded an all-time high. The S&P did not. Since then the S&P has nearly reclaimed its 2012 high while the Russell 2000 is about 5% away.

The S&P 500 is about 10% away from its 2007 all-time high, while the Russell 2000 is only 6% away from its 2011 all-time high.

If you are looking for a divergence between the S&P 500 and Russell 2000, you’ll find more than just one, some bullish, some bearish.

The chart below shows immediate resistance for the Russell 2000 and S&P 500 Index (red lines) and short-term support. There are indicators that suggest an upcoming sell off, but as long as prices remain above short-term support (green lines) the trend is up.

 

Financials – Is the Most Despised U.S. Sector Getting Ready to Rally?

Investors are shunning the financial sector. Although financials account for more than 14% of the S&P 500 (SPY), investors (by one measure) have only 2% of their money invested in financials. Some contrarians take this as a buy signal, is it?

Knight Capital, MF Global, LIBOR fixing scandal, JP Morgan losses, excessive Wall Street bonuses … there seem to be unlimited reasons to dislike the financial sector (Financial Select Sector SPDR ETF – XLF).

When it comes to financials, investors are not only talking the talk, they are walking the walk. Right now financials are the most despised sector in the United States. Of the $900 million invested in Rydex sector funds, only $18 million are allocated to financials, that’s just 2%.

However, the financial sector accounts for 14.21% of the S&P 500 Index (SPY), which makes it the second biggest sector of the S&P (behind technology).

Extreme pessimism often results in unexpected price spikes. Is the financial sector getting ready to rally?

The Technical Take on Financials

Financials appear to be at an important short-term juncture, but let’s provide some long-term context before looking at the short-term.

From the 2009 low to the 2011 high, the financial sector (XLF) jumped from $5.88 to $17.20. Before that, XLF dropped from 38.15 to 5.88. Today XLF trades 61% below its all time high price tag of 38.15. In comparison, the Dow Jones Industrial Average (DJIA) is less than 8% away from its all-time high.

Important short-term resistance for XLF last week was at 14.85. This resistance was made up of the July 3 and 27 highs and a trend line that connects the March 27 and May 1 highs.

On August 8, XLF was able to close above 14.85. Such a break out is generally bullish. However, the volume on which XLF broke out was significantly lower than average (see chart below).

Based purely on the chart and sentiment, the bullish message deserves the benefit of the doubt as long as XLF remains above 14.80. But a break below 14.80 would severely ding the immediate up side potential for XLF.

What about the down side risk? Aggressive investors may decide to sell or go short XLF with a break below 14.80. The initial down side target would be around 14.45 – 14.50.

Sentiment Picture – Stocks are Not Ripe for a Prolonged Decline

Sentiment readings have sent conflicting messages. The VIX is near danger levels for the S&P 500 while the AAII crowd is almost record bearish (which is bullish for stocks). Here’s the current sentiment picture and what to make of it.

Investor sentiment is closely related to money flow and therefore an important indicator. How is sentiment related to money/cash flow overall liquidity?

Investor sentiment tells us how investors feel about stocks. If they are bullish, we assume that they own stocks. If bullishness reaches an extreme, we know there’s not much more cash left for buying.

If investors are bearish we assume they are sitting on a mountain of cash. The cash will go to work eventually and drive stocks up.

There are different ways to measure investor sentiment.

The CBOE Volatility Index (VIX) uses S&P 500 index options and projects the market’s expectation of 30-day volatility. Readings around 16 or below are indicative of investor complacency and tend to result in an up tick of volatility and lower stock prices.

The Equity Put/Call Ratio represents a proportion between all put and call options purchased on any given day. A low put/call ratio means that investors are buying more calls than puts. This is a reflection of bullish sentiment; therefore readings around 0.6 tend to coincide with market tops.

A high put/call ratio means that investors are buying more puts than calls. This is indicative of fear. Readings of 0.9 tend to occur at the end of down trends.

The sentiment survey conducted by the American Association for Individual Investors (AAII) reflects how individual investors feel about stocks: bullish, bearish or neutral.

Investors Intelligence (II) polls investment advisors and newsletter writers. Their opinions are categorized as bullish, bearish and correction.

There are other sentiment and cash flow measures, but those four offer a balanced few of sentiment.

The Profit Radar Report always monitors sentiment and publishes a detailed sentiment report at least once a month. The chart below was published (available to subscribers only) on July 20, 2012.

The VIX was trading below 16 (bearish for stocks) while AAII investors were extremely bearish (bullish for stocks). II investment advisors on the other hand were becoming more bullish as the AAII crowd turned bearish.

Unfortunately, sentiment did not provide a clear signal then (it still doesn’t), but it showed a) that stocks may not be able to decline for good and b) that there was no high probability trade set up. This prevented investors from making trades they might regret afterwards. Based purely on sentiment, choppy market action may continue.

 

What A Difference Would QE3 Have Made?

“No QE3 for you” the Federal Reserve said on Wednesday. The market showed it’s disappointment. What a difference would QE3 have made?

“Central bank interventions are like sausages. They taste better if you don’t know what’s in them.” – Some German guy who writes a Newsletter.

The Federal Reserve and European Central Bank have cooked up a smorgasbord of ‘financial sausages’ since the 2007 bust. Stuffed in appealing high performance casings, the Fed was able to sell all kinds of smelly sub-par trimmings (QE1, QE2, etc.) as prime beef.

Few people cared because stocks were up and the sausages looked good. After a few cases of financial food poisoning however, people are starting to wonder what the Fed and ECB have been mixing in their QE sausages.

Still, for some “odd” reason Wall Street is begging for more of the same. This week the Fed played hardball and didn’t allow more than a sniff of the next sausage. That’ll have to do for now.

No Accountability to a Higher Authority

The chart below emulates the label central banks have been putting on their faulty products. The slogan is something like this: “Financial sausage consumption increases wealth.” At first glance, who could argue? QE1 resulted in higher stock prices, so did QE2 and LTRO I + II. The Dow Jones Industrial Average (DIA) trades only 9% lower today than 58 months ago at its all-time high.

But the DJIA is not the only measure that matters. People can’t eat DJIA, and the kind of indicators that measure prosperity (or lack thereof) of average American’s look pretty dismal.

Below is the one chart that shows what QE can and cannot do and who QE does and doesn’t benefit (hint: Wall Street bankers still get to celebrate their bonuses at Ruth’s Chris).

2007 vs. 2012

The Dow Jones today is only 9% below it’s 2007 peak reading.

Unemployment is about 85% higher today than in 2007.

U.S. debt (based on Treasury issuance) has roughly doubled since 2007 and is about 4 times higher than in 1995.

Starting in 2008, the U.S. has consistently been running monthly deficits.

The number of Americans on food stamps is almost twice as high as in 2007.

The balance sheet of the European Central Bank has ballooned by about 100%.

The Dow measured in the currency that’s hardest to manipulate (gold) is lower today than in 2007.

Election Year “Bonus”

This year is an election year. The incumbent party will do what it takes to stay in the drivers seat and the Fed (and ECB) won’t hesitate to resuscitate.

Is it money well spent? Wall Street will tell you yes. 46 million Americans on food stamps will beg to differ. Wall Street feasts on prime rib while the average Joe is stuck with the “Fed’s sausage.” No food stamps needed.