James “Rev Shark” Deporre has a message for investors – even though the S&P 500 and the Dow Jones Industrial Index are convenient, don’t overweight them in your portfolio.
“A large proportion of the discussion in the financial media is focused on the Dow Jones Industrial Average, S&P 500, and Nasdaq,” Deporre wrote recently in Real Money. “These indices are media shorthand for the stock market. If the S&P 500 is up today, then the market is good, and if it drops, then it was a bad day.”
Rev Shark acknowledges the major indices are a convenient way to talk about the market in general, adding there is some correlation between what the indexes are doing and the movement in the majority of stocks. ‘Indeed, if we didn’t have indexes, then the folks that write headlines about the stock market would have a much tougher job because there needs to be some form of generalization to convey what is going on,” Deporre said.
As history shows, however, generalizations are often wildly misleading.
“The problem for traders and investors is that indexes often cover up the opportunities or problems that exist in individual stocks. The indexes have been particularly misleading in 2021,” Rev Shark noted. “They have consistently hidden broad weaknesses in growth names, small-caps, and speculative stocks. They have also sent a misleading message about the overall technical health of the majority of stocks.”
Deporre said that, based on the market indexes, there’s a common perception that most of the market is wildly extended and must be very expensive. That’s not so – approximately 55% of all stocks aren’t even trading above their 200-day simple moving average of price.
“There are two basic types of markets: those that are driven by the indexes and those that are driven by stock picking. Index-driven markets are usually caused by macro news flow,” he added. One good example came on a recent Monday “as concerns about the Evergrande situation in China caused very broad selling. The merits of individual stocks didn’t matter much, as everything was dumped in tandem due to the big-picture concerns.”
Typically, downside action tends to be more index-driven than upside action. When all stocks are sold together due to macro worries, this almost always leads to stock-picking driven markets. “Once the index-driven selling is over, traders and investors sort through the wreckage and start identifying those stocks that have been unfairly sold,” Deporre said. “The best bargains are created when there is panic in the indexes and stocks are sold due to fear and disgust.”
It’s better, Deporre said, to view the indexes as a separate asset class. “They obviously can be and are traded in a vacuum without regard to what the majority of stocks may be doing. Timing indexes is extremely difficult and the vast majority of traders err on the side of being too early when they try to call market turns.”
Not only is index timing difficult, but it can be distracting when you are focused on it excessively. “I’ve found I often miss out on good trades when I’m obsessing over whether the indexes are going to move in a certain direction,” Rev Shark concludes. “In most cases, I’d be better off if I simply traded an individual stock rather than fooled with the indexes.”