Indices such as the S&P 500, the Nasdaq and the Dow Jones Industrial Average (DJIA) are used by the media and market participants as ways to measure overall market health. The theory is that the action in the indices is representative of the movement in the majority of stocks in the market.
Sometimes the indices do a good job of indicating what is going on in the market. There are times when the action in stocks is highly correlated and they all move in tandem, but the markets generally aren't that black and white. There are other times when stocks are not that correlated and the indices tend to mislead rather than illuminate. As Jim Cramer has often said, "There is always a bull market somewhere."
Recently the indices have been corrupted to a great degree by the big-cap technology names that I call the FATMAAN stocks. Since the indices are mostly constructed using market capitalization, the biggest stocks have the most weight. At the end of April, the FATMAAN stocks represented around 22% of the indices and that went even higher in subsequent months. In other words, these seven stocks offset the market action of hundreds and thousands of smaller stocks.
To navigate the market effectively we need to look beyond the indices and the action in the few names that dominate the indices. Sometimes these big-cap names are true leaders and we need to follow them. The indices will always have an impact on market sentiment. When the indices are sinking it will cause some market participants to stay on the sidelines and not buy stocks even though they may have positive prospects.
The current market is a particularly good example of how the indices can mislead. The FATMAAN names saw wild momentum for months that drove the indices steadily higher. The vast majority of smaller stocks were not correlated with that action. The FATMAAN names finally corrected and pushed the indices down and many secondary stocks are still not correlated with that action.
If you simply look at the major indices right now, they look quite poor. They are under pressure and are struggling to hold key support levels. There is an obvious case for shorting the indices. However, the underlying action is much more mixed. As I keep pointing out, there is some excellent action in individual stocks. Traders that have focused on special purpose acquisition companies (SPACs), biotechnology and select small-caps have been able to avoid the weakness in the indices.
The question at this point is whether the indices continue to deteriorate and whether that kills sentiment for stock picking. It is tough for stocks to buck the trend for long when the indices are breaking down and the danger is that the selling will be correlated.
My game plan is to stay very aware of the precarious position of the indices but to focus on stock picking and what is working. If the selling becomes more correlated, then strong defense will be required. However, if the rotation out of the FATMAAN and into other sectors continues, then stock picking will remain robust.
We have some bounce in the FATMAAN names in the early going here on Friday morning but it is quiet out there.