Rolling with it

Rolling with it.  Equity markets were able to float into a positive close yesterday, though the animal spirits of prior sessions took a well-deserved break.  On a quiet, low volume day the S&P500, the Russell 2000, and the NASDAQ 100 indices all eked out new highs yesterday and Dow Jones came to rest just around 2% below its all time high.  Yields went up as bonds traded off bringing the 10 year yield up to 2.87% right below some weak resistance (see chart 20 in my attached daily chartbook).  Bond traders will continue to pressure bonds and yields will look to rally up to their 2.94% Fibonacci resistance line capitalizing on recent gains in equity markets.  The market moves in the major indexes were attributed to a strong consumer confidence number, positive movement in Canada trade negotiations, continued positive sentiment on last weeks Mexican trade deal, and finally momentum (which is an ever-present factor).  So, a lazy, late summer day with not much in the way of major breaking news banners on CNBC and we get a lazy rally.  Nothing new right? Well, its not exactly that simple.  I like to point out that there are interesting patterns that can exist amongst and between the various indices that can give us further insight into equity markets.  To better understand these patterns one should be familiar with the makeup of the various indices that are so frequently quoted and even traded.  So let’s go back to the basics because it is, after all, geek-out Wednesday.

An index is an indicator which is designed to track the performance of a group of securities.  So we can say things like “stocks are going up” versus things like “Tiffany is up, BestBuy is down, Fangs are killing it, oh PG&E is um up up up”, etc.  So what’s in an index?  An index is a theoretical portfolio of securities which are selected to represent a specific group or style of investing.  At a high level the securities in the portfolio can be weighted by either their relative market capitalization or in an equal fashion (there are other ways but these two are the most common). Let’s start with the Standard and Poor’s 500 Index as an example.  The S&P500, perhaps the most watched index, is composed of the 500 stocks with the largest market capitalization traded on the New York Stock Exchange and the NASDAQ.  The index is capitalization weighted, which means that components with larger market caps have a bigger impact on the movement of the index. On the S&P 500 the top 10 weighted stocks are Apple, Microsoft, Amazon, Facebook, Berkshire Hathaway, JP Morgan Chase, Alphabet C, Alphabet A, Johnson and Johnson, and Exxon Mobile. Those top 10 stocks, alone, represent 21% of the entire index.  One could say that they have a lot of influence on the market.  The index in its current form, came into existence in March of 1954 and it is calculated utilizing a proprietary method every 15 seconds. The indices are typically viewed based on relative performance with less emphasis on the actual number.  In other words: did it go up or down and by how much.  So one can see that the index offers us a good representation of a diverse slice of the US stock market, which is why the S&P 500 is often quoted as the equity bellwether.  In 1982, the Chicago Mercantile Exchange introduced the first S&P 500 futures contracts which, for the first time, enabled traders to trade the index for hedging and speculation.  In 1993, State Street Advisors offered the first exchange traded fund that tracked the S&P500 Index and was initially called the SPDR (Standard and Poor’s Depository Receipt) and ultimately become known by its well-known ticker SPY.  The SPY is the second most traded ETF by volume and a variant of the S&P500 future is the most popular equity future by open interest, underscoring the importance of the underlying index.  Ok, Ok so there is an index, which is important for tracking a specific group of stocks, that index is strongly impacted by the biggest stocks in the group, and the index is tracked by futures and Exchange traded funds enabling investors to speculate and hedge.  Why would an investor buy or sell the ETF or future?  The most obvious answer is cost effective diversification.  When one can own a portfolio of 500 stocks, performance and risk are spread out across 500 different companies minimizing exposure to individual company risk (Modern Portfolio Theory delves deeply into this topic, and so will we on another geek-out Wednesday note).  The diversification offered by owning an ETF is a big factor in the rising popularity of ETFs.  Another reason for an investor to position an Exchange Traded Fund is to gain exposure to a specific style, industry, sector, or instrument.  Now that we know the S&P500 index is a large cap index and how to get exposure to it, we can similarly describe the other indices that I frequently mention in my note.  At a high level, the NASDAQ 100 is very similar to the S&P 500 and is a cap weighted index that tracks the largest 100 non-financial stocks traded on the NASDAQ exchange.  Because of the history and listing requirements of the exchange, the components of this index tend to be more growth-oriented than those of the broader and larger S&P500.  It can also be traded with futures and is most commonly traded through the ETF QQQ, which is sometimes referred to as the Q’s.  The Russell 2000 index contains the bottom 2000 capitalized companies on the broad Russell 3000 index, which is a cap weighted index that seeks to represent the entire US stock market (Muriel Siebert is a proud member of that index).  So the Russell 2000 is a broad cap-weighted index offering investors exposure to small cap stocks in sharp contrast to the large caps of the S&P500.  The Russell 2000 can be traded in futures or the ETF IWM.  Finally, we have the Dow Jones Industrial Average, which is the second oldest stock index (it dates back to 1896) and is compiled to represent the US economy and consists of just 30 stocks.  Historically it represented heavy industry but as the US economy evolved the Index became more diverse better representing the current economy (it includes a diverse group of companies from Exon Mobile, to J&J, to Disney, to Caterpillar, to Apple).  The index is price weighted, so changes in relative price give component companies a leg up in the mix.  The Dow, as it is often referred to, is often quoted but it is the least traded of all the major indices.  It can be traded as a future contract or with the ETF DIA.  So, in summation you can see that all of these major indices can give us a good benchmark or view into a specific group of stocks thereby giving us a better understanding of the health and direction of the overall markets.  So when I say that the NASDAQ is leading the pack it can mean that investors are betting on more speculative growth stocks.  If the Dow is lagging, investors may be worried about the trade war’s impact on large industry and so on.  There are many indices to watch and trade, all of which can offer key insights what lies beneath the surface.

Quarter over quarter GDP was released this morning showing that the economy grew an annualized rate of 4.2% versus the expected 4.0% and personal consumption increased at a lower than expected 3.8%, which is consistent with the “things are good, inflation is under control” narrative of the Fed.  Tomorrow, we get the important PCE deflator leaving us to another potential low volume, pre-vacation, late summer trading session.  Will all the indices continue to bubble up or will some lead or lag the pack to give us a hint into what investors are really thinking?  It’s hard to tell at this point, but one things is for sure, we will be watching… carefully.