By: Chris Rowe — September 8, 2020
How to Get a "True View" of the Stock Market
The "True Market" style of investing rests on two strong pillars -- market "internals" (also known as market "breadth") and "relative strength".
Let’s make sure that we really understand what we’re looking at when we turn on the news and see what the popular indices are doing.
Did You Know the 2000 – 2002 Bear Market Started in 1998?
If you know what I’m referring to, then you probably already have a good understanding of the importance of breadth indicators.
If you don’t, here it is in a nutshell.
Only a small handful of stocks were responsible for taking the popular market indices (especially the NASDAQ) to astronomical levels during that time.
When indices are making new highs, but breadth indicators are negative (the majority of stocks are trading lower), this indicates negative market strength and it's usually a precursor to a market top.
Beginning in mid-1998, the breadth readings got worse and worse until finally, in March of 2000, the NASDAQ dropped 1,862 points (-36%) from 5,132 in just over a month. It went on to decline 78% from the top.
The fact that most stocks started moving lower around April of 1998 isn’t even the fascinating part.
What intrigues me is that so many experienced, savvy Wall Street veterans (who should've been expected to understand what was happening) still stayed fully invested through 2001.
Again, the actions taken by the folks who “should have known better” speak volumes about the power of greed.
Even when you have technical analysis tools at your disposal (tools which are supposed to help take the emotion out of investing), what it really comes down to in the end is your ability to control your emotions (and listen to the indicators).
Most investors are familiar with the popular indices such as the “Standard & Poor’s 500 Index,” the “NASDAQ Composite Index,” the “Dow Jones Industrial Average,” and the “New York Stock Exchange Index.”
Referred to as the “external stock market,” these are what most folks use to get a read on the strength of the market.
But these indices never give us a true picture of what's really important. They don't tell us what percentage of stocks are actually participating in a market advance or decline. Therefore, they don’t reflect the true strength of the stock market.
Here's why this is the case...
The S&P, NASDAQ, and NYSE are “capitalization-weighted averages” of the stocks which represent each of these indices.
When I say that they're weighted by capitalization, it means that the prices of the larger companies are given more weight in the calculation of the index than the prices of the smaller companies.
A company’s "market cap" is the market value of the company’s stock. It's found by simply multiplying the price of the stock by the number of outstanding shares.
So even if a small handful of the largest companies on the NASDAQ move higher, while a much greater number of stocks on the NASDAQ move lower, the NASDAQ might move much higher anyway.
This is how, even though the NASDAQ consisted of over 3,500 stocks, the majority of the gains in the NASDAQ in 1999 were made because of the price advancement of only 10 or 12 stocks!
Everyone saw the NASDAQ moving straight up, but when they diversified their portfolio like they were told to, they didn’t see the same returns that the NASDAQ saw.
Instead, the way to make thousands of percentage points was to be in the top 0.3% of the stocks on the NASDAQ.
It drives me nuts when I hear people refer to The Dow Jones Industrial Average as “the market." This couldn’t be any less accurate. The fact is that the Dow is outdated and doesn't truly represent the overall market, as it only represents 30 stocks.
Unlike the S&P 500, NASDAQ, or NYSE, the Dow Jones is a price-weighted index. In other words, it overweights the performance of companies with higher-listed stock prices.
What Does All This Teach Us?
Stock market advances are stronger when they include a larger number of advancing issues than when just a select few are increasing.
Obviously, if a larger number of stocks are trending lower, your odds of picking a dog are higher. And your odds of picking a stock that trades higher are lower.
Also, if the majority of stocks are trading lower while the cap-weighted indices are moving higher, it’s likely that the cap-weighted indices will soon follow the crowd and move lower.
Then, when people see those popular indices moving lower, it causes a bearish mood amongst investors which pushes stocks even lower.
That's a true lose/lose scenario... and one you should avoid like a counterfeit bill.