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Everything may not be what it seems
October 13, 2014
by Brian Wolf

As a financial planner, one of my duties is to provide my clients with access to some of the best money managers in the country; and in working with these top investment managers, I also learn what these successful (managers look at).

Although I tend to not use complicated terms or language in my column, I think every now and then, I need to pull back the curtain and show you what the money managers are considering. One of our best tactical money managers is currently in a 100 percent cash position with our client's money, and here is one of the reasons for that move.

As of Sept. 25, 2014, the NASDAQ Composite index is up 6.95 percent year-to-date, despite the recent downturn in the market. The darling tech stocks continue to come up with new and innovative ideas for products and services to drive their bottom lines. The NASDAQ is only down -2.86 percent from the high it made Sept. 2, 2014. One could conclude that the NASDAQ is indeed solid and that this is just another passing correction before it pushes on to higher levels.

But what if I told you that 1,251 (48.9 percent) of the 2,558 stocks in the NASDAQ Composite index were down 20 percent or more from their 52-week high as of Sept. 25? Would you still think that the NASDAQ seemed promising? What if I told you that 852 (33.3 percent) of the stocks were down 30 percent or more from their 52-week high? Would you be surprised?

It would be natural to question this information because the two ideas don't seem to fit together.

The NASDAQ just hit a recent high, yet here we find that 48.9 percent of the stocks are down 20 percent or more from their 52-week highs. The former suggests that the index is strong and ready to push higher. The latter sounds like an index in the midst of a bear market. You may wonder how this could be.

The answer is market capitalization. The NASDAQ is a market capitalization-based index. This means that the larger the market capitalization of any given stock, the more the returns of that stock count in the index's performance. The largest stock by market capitalization in the NASDAQ Composite index is Apple, with a 7.3 percent representation. That's a very large portion of return.

To further show the disparity between the larger capitalization and smaller capitalization stocks in the NASDAQ Composite index, let's take the top 200 and bottom 200 stocks by market capitalization as of Sept. 25, 2014. Each group of 200 represents approximately 7.8 percent of the 2,554 stocks in the NASDAQ composite index by number. The top 200 stocks in the NASDAQ Composite index by market capitalization, while being 7.8 percent by number, represent just shy of 75 percent of the entire market capitalization for the NASDAQ. This means the remaining 2,354 stocks, just a bit over 92 percent of the stocks in the index, represent only 25 percent of the index's market capitalization. That's heavily skewed.

If we look at the year-to-date returns from these two groups of stocks, we see something even more amazing. The top 200 market capitalization stocks have an average year-to-date return of 13.92 percent. Meanwhile, the bottom 200 market capitalization stocks have an average year-to-date return of -10.49 percent. Yes, that is a negative. There is a pretty drastic difference between the two groups of stocks at the opposite ends of the market capitalization spectrum.

You may think that if we included, more stocks from the lower market capitalization levels, the results will improve. Let's see. If we include all the other stocks with year-to-date returns, excluding the top 200 market capitalization stocks, we end up with a return of -1.97 percent. Yes, the return did improve, but -1.97 percent is still a far cry from the +13.92 percent of the top 200 market capitalization stocks.

What does this tell us? First, the larger capitalization stocks count for much more than the smaller stocks, even though there are far more of the smaller stocks in number. In fact, the year-to-date returns for the top 8 percent of stocks by number are carrying the index for the remaining 92 percent. The market capitalization effect is making the index appear to be strong by hitting new highs when it is actually weak, based on an average numerical basis.

When a few large darling stocks carry the index higher while the rest lag, we refer to it as a narrow rally in stocks. Narrow rallies are a sign of weakness and are an insight into the true health of the market at large.

There was a similar narrowing of the stock participation in the NASDAQ Composite index in the time leading up to the market crash back in 2008. As of Dec. 31, 2007, the NASDAQ was up 9.81 percent year-to-date. Dec. 31, 2007; 75 percent of the stocks by number in the NASDAQ composite index were down 20 percent or more from their 52-week highs. Fifty-eight percent of the stocks by number were down 30 percent or more from their 52-week highs. This is similar to the narrowing we are seeing today. It can be seen as an early indication that something is amiss and careful monitoring is called for.

If you think that you might be in need of a second opinion on your investments, please give us a call for your complimentary risk and performance investment evaluation.



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