The Edmond Sun

Business

April 26, 2013

THE ASTUTE INVESTOR: Keeping up with the generals

EDMOND — 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. Now what?

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)? Or the ISM manufacturing index dropped from 54.2 to 51.3 in March, its third monthly decline? Or the ISM non-manufacturing (service sector) index also fell sharply in March? Or only 88,000 jobs were created in March compared to a forecast 200,000? Or retail sales fell 0.4 percent in March — the biggest decline in nine months? With that as backdrop, what could possibly go wrong?

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. The CRB Index fell 15 percent in the summer of 2010, and the S&P 500 fell 15 percent in that summer’s correction. In 2011, the CRB fell 15 percent and the S&P 500 declined 19.5 percent. Last year the CRB fell again, and the S&P fell 11 percent to its early June low. So it’s not very comforting that as the Dow makes new highs this spring, the CRB Index is down more than 12 percent so far from its last peak.

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 only contains 100 stocks. In the 11 years from 1988 to 1999 there were 256 changes in the stocks that comprise the S&P 500.  Between 2010 and 2012 there were 40 more changes.

Obviously, the fact that the indexes come back has little relevance as to whether the stocks buy and hold investors need to come back have done so. 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.” Thanks for reading.

NICK MASSEY is a financial adviser and President of Householder Group Financial Advisors in Edmond. Massey can be reached at www.nickmassey.com. Securities offered through Securities Service Network Inc., member FINRA/SIPC.

 

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