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I wrote to Bruce privately thanking him for the great articles. He replied:
> Could you post the attached message with the subject reading:
>
> MARKET BREADTH CRISIS... MYTH EXPOSED
So here it is......
---------------------------
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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