Measuring the Market – October 2006

October 24, 2006

Dow Jones Average: 12,117
S & P 500 Index: 1,377


Measuring the Market

The news media is full of reports about the stock market hitting record highs. The psychology and investment strategy of many investors are affected by the dramatic headlines. People react emotionally when they hear such news, some deciding that they should get on board before they miss the boat, while others worry about holding stocks at elevated prices. All the noise about the record high achieved by Dow Jones Industrial Average is obscuring the simple fact that the broad market is still far from record territory. The Dow Jones Industrial Average which consists of thirty companies is an old index that dates from the early 1900’s. It is still a popular market gauge with the mass media, but is seldom if ever used as a benchmark for broad market action. The thirty stocks in the Dow Jones Average are too narrow a list to encompass the entire market. And it is the only average that is not weighted by capitalization. Companies included in the Dow Jones carry weight based solely on their stock price rather than the overall value (shares outstanding times price) of the company. Large declines in the most widely held, highly capitalized Dow components such as GE, IBM, Pfizer, Intel, and Microsoft, can be more than offset by upward price movement in smaller Dow companies such as Boeing or Caterpillar Tractor. The Dow Jones Average does not reflect the changing market value of its own components let alone the entire market.

The averages commonly used to reflect the U.S. stock market are the Standard and Poor’s 500 Index, the NASDAQ, and the Wilshire 5000. These indices include hundreds or thousands of companies which carry weight in the index based on the market value of the companies. None of the broad based, market indices are at record highs. The S&P 500 index is about ten percent below the high it reached six years ago in early 2000. The NASDAQ is more than fifty percent below its astronomical high reached in March of 2000, and the Wilshire 5000 continues to trade below the high it also achieved in March 2000. When one adjusts for the general inflation of the past six years, all of the indices, including the Dow, are even further from record territory.

The media outlets run stories that pull in viewers, without much concern for portraying a complete, factual picture. The truth is that CD’s and treasury notes have outperformed the major U.S. stock indices over the past six years. On a total return basis, bonds that are held to maturity always lead to more money in investor accounts. It could be reported that bonds produce record highs in investor accounts on a daily basis, but that would be a dull story that no one would read. Because inflation offsets much of the return earned on fixed income investments, bonds have never been viewed as a way to significantly alter one’s financial situation. Stocks also have to be evaluated relative to inflation. On an inflation adjusted basis most market indices are still twenty five to thirty percent below the highs reached in 2000.

There have been ways to make money in stocks over the past six years. Foreign stocks have outperformed U.S. equities. The shares of smaller companies outside the tech sector have done well. Energy companies have made meaningful upward moves, in spite of recent pullbacks. But the largest, widely owned companies that dominate the broad based market indices, and make up the core of most domestic mutual funds, continue to sell for prices well below their former highs.

Current Strategy

While the stock market has not reached a new high by most measures, it has gained significant ground since July, when it was actually at a loss for the year. Investors came back to the market in August, when it became apparent that the Federal Reserve board was finished for the moment with its policy of tightening interest rates. The Fed paused because data indicated that higher interest rates were starting to retard economic growth. In July investors were worried about higher interest rates and economic contraction. While fears of an economic slowdown remain, the specter of higher interest rates has been removed. Stocks that are less reliant on economic growth, i.e., consumer, medical, and technology companies, have gained the most since July. Economically sensitive stock groups that were strong in recent years have faded noticeably in recent months.

The recent shift in market trend has evened out the performance between sectors of the market, leaving almost everything somewhat overvalued in our opinion. We are not seeing the kind of extreme over valuation that we witnessed in 1999-2000, because despite the misleading headlines the market is not back to those levels. At the top of the bubble, the big capitalization, growth companies and the tech companies were grossly overvalued, while smaller non-tech companies were generally undervalued. This juncture in the stock market is different in that prices are now uniformly high. Almost every stone has been turned over as investors scour the landscape for companies that are still undiscovered and undervalued. The movement of money to hedge funds and private equity funds is a symptom of excess capital chasing a shrinking numbers of good opportunities. We have been in a profit taking mode this year, as many holdings reached our price objectives.

The bond market has become more attractive as rates have moved from one to five percent over the past eighteen months. In June and July we bought straight treasury notes that yield about five percent and come due in two to three years. In recent days we have moved funds back into the TIPS (treasury inflation protected securities) that served our clients so well from 2001 through 2004. The TIPS currently yield almost three percent of regular income plus the going inflation rate which has been above three percent this year. This is a relatively high return for TIPS. The TIPS became too popular and expensive in 2004-2005 and have only recently become cheaper again. It seems that certain investor have cashed in their TIPS in order to join the stock market rally. As usual we are doing the opposite, selling stocks at high prices and buying a less favored asset class.

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