For Wall Street, it just doesn't get any better than this. As of this writing the new Dow Jones Industrial Average has risen 20%, the S&P 500 is up over 15% and the NASDAQ has achieved a parabolic rise of over 53%. On Wall Street, they will be handing out more than just million dollar bonuses. It will be time to break open a bottle of Dom Perignon and light up a Macanudo. For the fifth consecutive year, if things hold up, the U.S. stock market will have achieved gains in the double-digits. Even better for Wall Street, it has been another record year for IPOs and mergers. For investment bankers this is as good as it gets.
Yet all is not well for fund managers and investors. Mutual funds are under-performing the major indexes. It has become more difficult to make money in a stock market that acts more like a wild bungee ride. What's more, the number of stocks that are under water are at near-record levels. On a daily basis there are more stocks declining than advancing—a condition that has existed since April 1998. In addition to the number of stocks that are declining, the number of companies that are reaching record lows far surpass the handful of companies that are achieving record highs. While the focus is on the major indexes, such as the Dow and the Nasdaq, the less-mentioned Russell 2000, Wilshire 5000, or the unweighted Value Line Indexes are treading water or are actually negative for the year.
The Giants Outshine the Dwarfs
This graph demonstrates that the major markets continue to advance; while the broader number of stocks continue to decline. How can this be? We have stock market indexes advancing, while the vast majority of stocks are declining. This disparity is a result of the way the indexes are computed. In the Dow, the stock with a higher price carries a greater weight than a lower-priced stock. So when a a high-priced stock such as GE (8/share), American Express (5/share) or JP Morgan (8/share) rise, they carry more weight in that index. Their current weights are GE at 6.123%, American Express at 6.893% and JP Morgan at 6.165%. [These weights change daily as the price of the shares rise or fall.] When these stocks rise, their rise adds more points to the Dow's advance. Consider the comparison to a stock like Philip Morris whose stock price is around a share and a market weight of 1.172%. There have been days when the Dow's rise has been due entirely to the rise of a single stock such as IBM, HP, or GE.
The Same Holds True for the S&P
The picture looks the same for the S&P 500. In this index of 500 companies, each individual stock is weighted by market value (the combination of the price of the stock times the number of shares outstanding). For the S&P, a stock like GE has a market weight of 3.834%; while Microsoft carries a weight of 3.726%. In the S&P, the top 4 companies represent 10% of the value of the index; while the top 10 companies represent over 20% of the value of the S&P. This index has 500 companies—yet 10 companies occupy over 20% of its entire value! Since a small group of companies represent a major portion of the index's value, these small handful of giants tend to move the entire index.
The Conundrum for Index Managers
As a stock's market value increases, its index weight increases. Since there are close to trillion in index funds in this country, each index fund has to proportionately weight it's fund to the index heavyweights such as GE and Microsoft. Because most stock funds have under-performed the major indexes, individual investors have been pouring more money into the index funds where results have been higher. This infusion of investor money pouring into the index funds forces the index fund manager to buy the same highly-weighted stocks, thereby driving the stock prices even higher. This action then increases their market value and increases their weight in the index. The whole process becomes self-perpetuating. Fund managers find it even more difficult to beat the index unless they become "closet" index funds by owning the largest companies within the index. The escalation of a handful of large-cap stocks is putting pressure on fund managers, which then causes their funds to under-perform.
The Pile-Up Mentality: "Everyone Wants the Guy With the Ball."
An analogy I like to use is borrowed from the game of football. The object of football is to score the most touchdowns and keep the other team from scoring. The defense's position is to stop the guy with the ball. So when that offensive guy catches a pass or runs with the ball, the opposite team tries to tackle him. We see the opposition pile up on the player with the ball. This "pile up" is true of today's stock market. Everyone wants the guy with the ball – in this case, the stock that carries the most weight. Today, we're seeing all the index managers pile on top of "the guy with the ball."
Resulting from this pile-up mentality, we see indexes that are rising; while the vast majority of stocks within the index are declining. The giants overshadow the dwarfs. This situation has produced the most lopsided market of this century—a market that has seen the price of individual stocks, and their subsequent market value, soar to unprecedented levels. Consider these facts. For the first three quarters of this year, just 11 stocks within the S&P 500 account for all of its performance. For the NASDAQ, the picture is even more distorted. There are 4,789 stocks listed on the NASDAQ. As of this writing, the index is up over 53%. However, a little more that 1% of the stocks listed within the index account for 99% of its gains. Four stocks—Microsoft, Intel, Cisco, and Worldcom—comprise 25.6% of its value
Never before in the history of our market have so few companies represented so much of the market's total value. In fact, the value of the top 10 NASDAQ stocks represent more than the value of the entire economic output of many advanced, industrial countries. This process of distortion – whereby you have the vast majority of stocks declining; while the indexes are advancing—has existed only a few times in this century. It existed during the 20s before the Crash, in the early 70's before the last bear market, and for a short period before the October Crash of 1987.
Distortion Is the Herd's Reality
This gross distortion of value is explained by market analysts as the new paradigm of the American economy. In their view, it is a new world whereby the old yardsticks of valuation, like dividend yields, P/E ratios and book value, should be thrown out the window. We are told that we're on the verge of a whole new economy that will be powered by technology and the internet which will drive perpetual growth to infinity.
This Wall Street "spin" is expressed 24 hours a day through financial news shows, magazines, newspapers, newsletters and network television. In my estimation, it amounts to 24 hours of noise and dribble that drown out the big picture and most of the facts. Market gurus suggest that all an investor needs to do is focus on growth and pony-up with any amount of money growth companies command. Although it is true that there are many companies that are growing at fantastic rates, it is also true that many of them don't make any money in the form of real earnings. To me, those that are growing command excessively high earnings multiples that border on the absurd.
Today, an intelligent investor is asked to pay as much as 2,171 times trailing earnings for Ebay, 1,195 times earnings for Yahoo, or 352 times profits for the internet blue-chip, AOL. Bargain hunters can buy Qualcomm at 153 times earnings. My favorite is Microsoft which is considered a bargain at 57 times earnings. [It's a "bargain" price because the Justice Department may consider breaking up the company or leveling a large fine for its monopolistic practices.] If you are a practical investor, and want to invest in the Internet without speculating, you are told to buy Cisco which makes network products that power the Internet. Cisco can be bought for a mere 106 times earnings. Today's trader considers it wise to be able to buy a company that is growing at 30% a year with a price of 106 times earnings.
Wall Street pundits would argue that those who question valuation are missing the picture. What is most important is earnings. Wall Street is constantly reminding individual investors,
"This time it's different. The level of profits are miraculous and have never before reached such high levels. It's a new age and a new time of prosperity for investors."
Is It Really Different?
In truth, profits for most of the S&P 500 peaked several years ago. In fact, the unprecedented profit Wall Street speaks of has more to do with Washington and the Federal Reserve. Those miraculous profits of the first part of this decade are due to the Fed lowering interest rates and Washington changing two aspects of the tax laws. As for the profit growth of the last three years—well that's another story. Suffice it to say, profit growth over the last few years has more to do with the creative imagination of corporate accountants than it does to new era earnings growth. For many of the highly-touted growth stocks, there are no profits at all.
This issue of miraculous profit growth will be covered in the next edition of Perspectives, "The Earnings Game". Many are saying the Stock Market and it's Dow will move perpetually higher. Several new books have recently been released which claim this truth. Dow 36,000, Dow 40,000 and Dow 100,000 are best sellers at your favorite book stores. If I were to jump in with their premises, I would say, "Why Not Dow 1,000,000?" But, my conscience and the facts tell me otherwise.
Perspectives Part 2 is an on-going series on the American stock market.
