"99% of all statistics only tell 49% of the story."
--Ron DeLegge II
The Dow Jones Industrial Average and the S&P 500 are supposed to provide a short-hand way to measure overall market health. In general, there is a strong correlation between the major indices and the action in the average stock, but there are times when these indices do an extremely poor job of reflecting the true state of the market.
We will hear much about the lackluster returns of the indices this year, but the business media will largely miss the big story of 2016, which is that the action has been far worse than it has appeared. It has been an extremely narrow market and that fact has been covered up the focus on major indices and those who tend to provide superficial coverage of market action.
Two statistics help to illustrated what is going on.
First, the top 10 stocks in the S&P 500 are up an average of about 20% for the year. The remaining 490 stocks are down an average of 3%. This is the biggest differential that has existed since 1999. This is why we hear so much about a group of stocks that go by the acronym FANG. The stocks, Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Alphabet/Google (GOOG, GOOGL) are part of those 10 names that have cornered gains this year.
Second, the number of stocks that are trading over their 200-day simple moving average is just 23.1%. The 200-day simple moving average is a good way to view the longer-term health of a stock. If a stock is below its average price of the last 40 weeks then no one is making much of a return on it. With just 23.1% of stocks over their 200-day moving average it is clear that the great bulk of stocks in the market have been money-losers this year.
The chart below illustrates how the S&P 500 has misled us about the true state of the market. Since July 1, 2014 the S&P500 is up about 2%. Most people would assume that means that most stocks are trading around flat during that period of time. That is not the case. The great majority of stocks have declined. The number of stocks over their 200-day moving average has dropped from 74.3% to just 23.1% at the close this past Friday.
If you review this chart, the reason for massive underperformance by fund managers and many individual investors in 2016 becomes extremely obvious. The vast majority of stocks have been trending down, while the benchmark indices are holding steady primarily due to a few bigger names. There simply is no easy way to beat the indices unless you are holding highly-concentrated positons in a few big-caps that are outperforming. If you hold an average stock, you just can't keep pace.
Obviously the reason that the major indices have been so misleading is caused by the way they are constructed. Most indices are capitalization weighted, so bigger names have much more influence. Strength in a few big-caps like Microsoft (MSFT) and Apple (AAPL) offset poor action in dozens of other stocks.
Due to its historical evolution, the Dow is constructed in an even worse manner. It is price weighted. The higher the price of a stock in the DJIA, the more influence it has on the index. For example, Goldman Sachs (GS) at $176 has about 6x the weight of General Electric (GE) at $30, although the market cap of GE is about four times greater.
Indices will never be perfect indictors, but the big problem is that the folks in the media seldom delve into what is really happening. For them, the Dow Jones is the market. If it is positive then everything is great, regardless of what 5,000 other stocks may be doing. This attitude impacts overall market sentiment and keep it artificially high because so many folks are using indexing for retirement funds and index ETFs for trading and investment.
One of the unfortunate consequences of a narrow and top-heavy market like this is that it creates pressure for it to stay that way. If the only way to produce relative performance vs, the indices is to buy a few big-caps then fund managers will continue to do so even more aggressively. The more they pursue this strategy the more other managers are forced to pursue it as well. The only alternative is to try to anticipate when it will stop working.
Eventually the tide will turn and when the big-cap names that have been holding up the indices experience selling pressure the indices will fall very hard, very fast. We had a taste of this on Friday as the most popular big-cap names performed poorly.
The good news is that much of the market has been undergoing a correction for a very long time. As the chart above shows much of the market has been trending down since July of 2014, so we are already well into corrective action. It will be very painful for the indices to catch up, but there are many stocks that are likely closer to their lows, rather than their highs.
Eventually the indices will once again better reflect the underlying action, but it is going to be a painful as that adjustment takes place. The indices are playing catch-up now, but the average stock isn't going to be able to do much while that takes place.