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bruceb@xxxxxxxxxxxxx wrote privately:
> SPY is the symbol for the S&P depository receipts. It's essentially a
> stock that tracks the S&P. Go to the Amex home page for more details.
>
> I'm having trouble posting anything to the Omega list (maybe I've been
> banned...). Could you please post the message attached for me?
>
> Thanks,
>
> Bruce
here BRUCE goes......
From: bruceb@xxxxxxxxxxxxx
To: <he96@xxxxxxxxxxxxxx>
Subject: RE: SPX and SPY
Date sent: Fri, 7 Aug 1998 09:43:15 -0400
From: bruceb@xxxxxxxxxxxxx
Sent: Friday, August 07, 1998 9:29 AM
To: Omega List
Subject: MARKET BREADTH CRISIS... myth exposed
The most prevalent reason you hear in the mainstream media these days for
the recent market correction is because the gains in the market for some
time now have been concentrated in a relatively small number of large cap
stocks, whereas small caps for the most part have been languishing. Every
bearish market technician and their brother has been in front of the
cameras with a chart of the advance-decline line showing just how
"unhealthy" this current situation is. Although big caps have certainly
been outpacing small caps, the notion that this is a dangerous situation
by historical comparison is completely false.
Since the Dow Jones Industrials is the most watched large cap index, I'll
refer to large cap stocks as Dow stocks. Obviously not all large cap
stocks are in the Dow, but the point is still valid. I'll refer to small
cap stocks as Russell stocks, because most people consider the Russell
2000 to be the best benchmark for small cap performance.
There are two primary reasons why no one should be concerned about the
growing disparity between the two indices. The first is already known to
anyone who (carefully) reads the WSJ. An article last Friday described in
perfect detail why Dow stocks have been (and should be) going up faster
than Russell stocks. Russell companies, being small but growing, have
been large net-issuers of stock during the market boom. Many of them not
only make a primary offering, but a secondary and even a third offering of
stock. These offerings may (or may not) be perfectly valid and proper
business decisions on the part of management to grow the business in the
long run, but the net result is that the supply of Russell stock has been
growing.
Dow stocks, on the other hand, have been primarily NET BUYERS of their own
stock over the past several years, which has therefore shrunk the supply
of Dow stock available to the public. Since most Dow CEOs are now
compensated with stock options, they have an enormous incentive to use
free cash to buy back stock (and drive the price up), rather than give it
back to existing stockholders in the form of a higher dividend (which is
also taxed at a higher rate).
The result of this situation is pretty simple. Even if the demand for
both Dow stocks and Russell stocks is growing, the greater supply of
Russell stocks relative to Dow stocks dictates that Dow prices MUST go up
faster than Russell prices. In other words, Dow stocks are rising faster
than Russell stocks BECAUSE THE LAW OF SUPPLY AND DEMAND SAYS THEY
MUST
(that should sound familiar to you by now...).
The second reason that the WSJ didn't bother to mention is a little more
interesting. If you stop and think about it, there is an inherent "bias"
against small cap indices like the Russell 2000 relative to large ones
like the Dow. Put in the simplest of terms, there are two types of
Russell stocks- successful ones and unsuccessful ones. We all know what
happens to the unsuccessful ones, they either tread water (and their stock
goes sideways) or they go bankrupt (and their stock goes to zero). It's
what happens to successful Russell stocks that is most important.
By definition, successful Russell stocks either grow and become a Dow
stock, or they are bought out by an existing Dow stock along the way. If
you think about it then, the Russell index is essentially "punished"
because its most successful members "graduate" (through growth or buyout)
to the large cap realm!
My favorite example is Cisco. Not too long ago, Cisco was a member of the
Russell 2000 (if I correctly understand how that index is compiled).
Since Cisco recently passed the $100 billion market cap threshold, I think
it's safe to say it now qualifies as a large cap. What if Cisco and all
the other Ciscos out there were "still" included in the Russell index?
The performance of the Russell would look a LOT better, wouldn't it? But
Cisco isn't included in the Russell anymore because of its phenomenal
size.
Although this bias against the Russell has always existed, it has clearly
become more acute recently, and therefore helps explain the growing
disparity. Because of the booming economy and stock market, Dow stocks
have a lot more money (and a high valued stock) with which to make
business purchases, and they're making these acquisitions even further
down the business food chain. It isn't uncommon to read about Microsoft
buying a small company for less than $100 million, which seems like a
waste of time for a $200+ billion company, but if that company has
promising technology, it's worth it. That tiny company may have gone on
to become a "star" of the Russell, but now it can't, and the Russell index
"suffers" for it.
Because of these two reasons, it's clear that the disparity between Dow
stocks and Russell stocks is not unhealthy nor dangerous. Comparing
today's market breadth situation to yesterday's is once again like
comparing apples to oranges because the supply and demand curves have been
fundamentally altered relative to the past. It's entirely possible that
this disparity will continue to get bigger for years to come, but it's not
going to stop the market as a whole from rising in the long term.
I feel I should point out one last thing. I know there are some very
clever members of this list who are saying to themselves right now: "wow,
if there's a bias against the Russell, I'll just short the Russell, buy
the Dow, get rich, and sleep safely at night knowing I'm fully hedged!"
If you had done that a year ago, you would've looked like a genius. Let
me warn you, however, that all I've done in this message is explain why
the Dow/Russell disparity makes economic sense in the current investment
environment, there's no reason why things couldn't change in the future.
I'm not saying it won't work, I'm just saying don't criticize the law of
supply and demand if it doesn't...
Bruce
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