Why is the S&P 500 Beating the Dow?

I often see one stock index outperform another, as different segments of the economy speed up, slow down, or go nowhere. Sometimes the reasons for this are fundamental, technical, or completely arbitrary.

Many analysts have been scratching their heads this year over why the S&P 500 has been moving from strength to strength for the past year, while the Dow Average has gone virtually nowhere. Since January, the (SPX) has tacked on a reasonable 7.9%, while the Dow has managed only a paltry 3.4% increase.

What gives?

The problem is particularly vexing for hedge fund managers, who have to choose carefully which index they use to hedge other positions. Do you use the broad based measure of 500 large caps or a much more narrow and stodgy 30?

What?s a poor risk analyst to do?

The Dow Jones Industrial Average was first calculated by founder Charles Dow in 1896, later of Dow Jones & Company, which also publishes the Wall Street Journal. When Dow died in 1902, the firm was taken over by Clarence Barron and stayed within family control for 105 years.

In 2007, on the eve of the financial crisis, it was sold to News Corporation for $5 billion. News Corp. is owned by my former boss, Rupert Murdoch, once an Australian, and now a naturalized US citizen. News then spun off its index business to the CME Corp., formerly the Chicago Mercantile Exchange, in 2010.

Much of the recent divergence can be traced to a reconstitution of the Dow Average on September 20, 2013, when it underwent some major plastic surgery.

It took three near-do-wells out, Bank of America (BAC), Hewlett Packard, (HPQ), and Alcoa (AA). In their place were added three more robust and virile companies, Goldman Sachs (GS), Visa (V), and Nike (NKE).

Call it a nose job, a neck lift, and a tummy tuck all combined into one (Not that I?ve been looking for myself!).

And therein lies the problem. Like many attempts at cosmetic surgery, the procedure rendered the subject uglier than it was before.

Since these changes, the new names have been boring and listless, while the old ones have gone off to the races. Hence, the differing performance.

This is not a new problem. Dow Jones has been terrible at making market calls over its century and a half existence. As a result, these rebalancings have probably subtracted several thousand points over the life of the Dow.

They are, in effect, selling lows and buying highs, much like individual retail investors do. It is almost by definition the perfect anti-performance index. When in doubt, always measure your own performance against the Dow.

Dow Jones takes companies out of its index for many reasons. Some companies go bankrupt, whereas others suffer precipitous declines in prices and trading volumes. (BAC) was removed because, at one point, its shares took a 95% hit from its highs and no longer accurately reflected a relevant weighting of its industry. Citigroup (C) suffered the same fate a few years ago.

Look at the Dow Average of 1900 and you wouldn?t recognize it today. In fact, there is only one firm that has stayed in the index since then, Thomas Edison?s General Electric (GE). Buying a Dow stock is almost a guarantee that it will eventually do poorly.

This is why most hedge funds rely on the (SPX) as a hedging vehicle and how its futures contracts, options and ETF?s, like the (SPY), get the lion?s share of the volume.

Mind you, the (SPX) has its own problems. Apple (AAPL) has far and away the largest weighting there and is also subject to regular rebalancings, wreaking its own havoc.

Because of this, an entire sub industry of hedge fund managers has sprung up over the decades to play this game. Their goal is to buy likely new additions to the index and sell short the outgoing ones.

Get your picks right and you are certain to make money. Every rebalancing generates massive buying and selling in single names by the country?s largest institutional investors, which in reality are just closet indexers, despite the hefty fees they charge you.

Given their gargantuan size these days, there is little else they can do. Rebalancings also give brokerage salesmen talking points on otherwise slow days and generate new and much needed market turnover.

What has made 2014 challenging for so many managers is that so much of the action in the Dow has been concentrated in just a handful of stocks.

Caterpillar (CAT), the happy subject of one of my recent Trade Alerts, accounts for 35.3% of the Index gain this year. Walt Disney (DIS) speaks for 24.2% and Intel (INTC) 23.4%.

Miss these three and you are probably trolling for a new job on Craig?s? List by now, if you?re not already driving a taxi for Uber.

It truly is a stock picker?s market; a market of stocks and not a stock market.

Believe it or not, there are people that are far worse at this game than Dow Jones. The best example I can think of are the folks over at Nihon Keizai Shimbun in Tokyo (or Japan Economic Daily for most of you), who manage the calculation of the 225 stocks in the Nikkei Average (once known as the Nikkei Dow).

In May, 2000, out of the blue, they announced a rebalancing of 50% of the constituent names in their index. Their goal was to make the index more like the American NASDAQ, the flavor of the day. So they dumped a lot of old, traditional industrial names and replaced them with technology highfliers.

Unfortunately, they did this literally weeks after the US Dotcom bubble busted. The move turbocharged the collapse of the Nikkei, probably causing it to fall an extra 8,000 points or more than it should have.

Without such a brilliant move as this, the Nikkei bear market would have bottomed at 15,000 instead of the 7,000 we eventually got. The additional loss of stock collateral and capital probably cost Japan an extra lost decade of economic growth.

So for those of you who bemoan the Dow rebalancings, you should really be giving thanks for small graces.

SPX 7-3-14

INDU 7-3-14

NIKK 2-28-03Rebalancing? Yikes!

 

CAT 7-3-14Miss This One, And You?re Toast

 

Changes in DowIt Truly is a Stock Picker?s Market

 

Mickey MouseThe Key to Your 2014 Performance