By Deborah DeMatteo
Managing Director & Chief Investment Officer
The month of July was a continuation of what we have seen so far this year, a market that is kind to a few and painful for many. Although the major averages such as the S&P 500 was up 1.97 percent for the month, it does not really tell the story of what is going on underneath the surface. A lot has been written this month about the deteriorating breadth of the market and the breakdown of an indicator known as the advance decline ratio. Breadth is the amount of stocks participating in the move of the market. The S&P is made up of 500 stocks; in addition it is a market cap weighted index, giving larger companies a greater impact. This can make the averages appear different than what a majority of the stocks in the index are doing. The advance decline ratio is simply the number of advancing stocks versus declining stocks on a given day or over a given time frame. During a “healthy” market advance, as you would guess, more stocks are advancing than declining. You can also look at the fundamentals of the market by looking at the number of new highs versus the number of new lows. All of these things are different ways that traders and market forecasters gauge the market strength beyond just looking at average performance. These valuable tools can help us understand what is going on at a level beneath the surface. During the month of July these indicators were telling us something different than a market up almost 2 percent.
Let’s start with some statistics within the Dow Jones Industrial Average. The DOW is made up of just 30 companies, yet we follow it as an indicator of the overall market that is made up of thousands of stocks. The companies within the Dow are generally considered some of the world’s greatest companies and widely held in conservative portfolios. The Dow was up only .4 percent for the month. When we look out at the DOW on a year to date basis it is now down .75 percent. Within these 30 names there is a wide diversion of performance. One third of the companies within the index are down over 10 percent year-to-date, with the steepest decline coming from Chevron down 24 percent year to date as of August 6th. Maybe even more striking is the fact that 43 percent of the DOW components have had a correction of 10 percent or more from their 52 week high including such names as Verizon, Proctor and Gamble, American Express, and Disney.
In the S&P 500 we are seeing a similar divergence. What I would refer to as a list of the “haves” and the “have nots.” Most frustrating for conservative investors is that the list of the “haves” is not the type of thing that generally makes up a large percentage of their holdings. So, let’s start with the basics. The S&P 500 was up 1.95 percent as of August 7th. In an index of 500 names, taking out just the top 9 best performing stocks, the index would be negative on the year. In an article written by Rob Isbitts, “Declining Market Breadth is a Troubling Sign,” he breaks out the trailing 12-month performance of several sectors. The highlights include the AMEX Biotech index up 45.8 percent and the Nasdaq Composite up 13.2 percent. While for the conservative at heart, the Dow Jones Select Dividend up 2.6 percent; the Amex Utilities Select Spider down 1.6 percent; and the Amex Select energy index down 26.5 percent. He further points to target risk indexes, noting the S&P Target Risk Aggressive Index up 3 percent and the S&P Target Risk Conservative index down .3 percent. With the NASDAQ up 13.1 percent and the NYSE is down 2.5 percent, it seems to show that all the action is currently taking place in the NASDAQ. He goes on to note, “conservative investors are feeling like they are missing out when all they are really doing is staying conservative, which is what many wellheeled retirees should do.” It helps to explain why if you look at just one or two references, such as the DOW and the S&P, it may not always be telling the whole story.
We can see this in the advance to decline ratios as well. During the month of July, the New York Stock Exchange had 16 days where the number of advancing stocks outpaced the number of declining stocks. However, there were 18 days that the number of decliners outpaced the number of stocks that advanced. This tells us that the number of stocks participating in the move to the upside is declining and that a small number of stocks are responsible for the performance of the averages. When you add the market cap weighting that the indices use, a few large companies can skew the perception of the performance of the overall index. Over the last 12 months only 2 sectors of the 9 sectors in the S&P 500, are negative. Year to date however, 4 of the 9 sectors are now negative. While the S&P 500 remains marginally higher for the year, 56 percent of the index is in correction territory, meaning it is more than 10 percent off its high.
An investment strategy is a long term process, not something that should change with the ebb and flow of the market and the sectors within it. Chasing what is working is a common mistake that catches investors buying near highs and selling near lows. The best performing sector for 2014 was utilities turning in over a 25 percent return last year. As of June 30th this year they were in the bottom of the pack losing over 10 percent for the year. It is important as money rotates from sector to sector to keep the long term in perspective. Over the last twelve years ending June of 2015, the best performing sector was consumer discretionary, with an average annual return of 11.7 percent. However, within that average it was down over 35 percent in 2008 and was the top performing sector in 2013 with over a 43 percent return. Although the long term average is very attractive, there were several years they were one of the worst sectors to own. Sometimes the numbers with the average are all closely correlated near the mean. What we have been seeing over much of the last year is a very wide range of performance and little correlation around the mean.
With news that China is continuing to slow and causing Government intervention in their currency and stock markets, the Greece debt issue still hanging over the Eurozone, lack of strong growth in the US, and the Federal Reserve waiting in the wings to raise rates; there is no doubt we will continue to see a broad dispersion in returns. Each of these things has an impact to a greater or lesser degree on specific sectors. Although it can feel like diversification is not working, the risk of not is far too great for conservative investors. Patience is an easy emotion when things are going well and it begins to fade very easily when fear and frustration move in. Remember that great investors make their money when fear and frustration drive emotional decisions. Patience and perspective will prevail during good times and tough times.