Point and Figure

We get asked — often — “how can you be so sure about these charts?  Look at what the market did yesterday!  Are you sure we’re doing the right thing?”

Now, one of our favorite movies is “My Cousin Vinny”  And when we hear these questions, it sounds a lot like the dialogue between Vinny (Joe Pesce) and Mona Lisa Vito (Marisa Tomei):

Vinny: How can you be so sure?
Mona Lisa: If you will look in the manual, you will see that this particular model faucet requires a range of 10-16 foot pounds of torque. I routinely twist the maximum allowable torquage.

One of “the indicators” we employ is a relative strength measurement of the S&P 500 vs the bond market.  Essentially, what this measurement tells us is, “is it better to be in stocks — OR are we better off in bonds?”

Here’s a picture of that chart, courtesy of our friends at Dorsey Wright:

So, what the heck does this mean?
Buy signals on this chart indicate it’s time to over-weight stocks instead of bonds.
And Sell signals indicate it’s time to over-weight bonds, instead of stocks.

This chart gave a sell signal in November 2000.
Then it gave a buy signal (over weight stocks) in summer 2003
It then gave a sell signal in July 2008 (time to under-weight stocks)
The chart then gave a buy signal in June 2009.
It’s been on that buy signal ever since.

Now, this is not the ONLY indicator we use.  It’s one of several indicators.  There will be times when this chart turns from a column of X’s into a column of O’s.  That only tells us that stocks are weak, sloppy, the market is messy — and our phone is going to start to ring.  That is OK.

So when we get days like yesterday (China down 7%, the US markets down a lot) it’s GREAT to have these indicators to fall back on.  It beats relying on the knuckleheads on CNBC, or the articles on Marketwatch.   Headlines on the Marketwatch website yesterday included phrases like “big losses” and “bear market” and “brace for big selloffs.”

Holy cow.

Your New Years Resolution should be to turn off/tune out that noise.  It will feed on your emotions and trick you into making a bad decision.

Last week, it was announced Apple will be added to the Dow Jones Industrial Average on March 19th.  Since the Dow Jones holds just 30 stocks, one has to go.  AT&T is being dropped on that day.

There is no “magic formula” for how a company gets added to the Dow Jones.  It’s put together by committee at publishing company McGraw-Hill, since they own the Dow Jones name these days.  That alone should make everyone cringe.  

But here are the two big issues I have with the Dow Jones, with a tip of the hat to Barry Ritholtz:

First, it is the Dow Jones INDUSTRIAL Average.  We don’t have much in “industrial” any more in the US.  When Charles Dow was not creating point and figure charts in the 1890’s, he assembled this index to get a “pulse” of how the US economy was doing.

Over the past few decades, the Dow has “morphed” to include service and technology companies.  Not very industrial.

Next, the Dow Jones is a price-weighted index.  Meaning, the higher-priced stocks have a bigger impact than lesser-priced stocks.

The highest PRICED stock in the Dow (Visa), has nearly a 10% impact on the move each day.  Goldman Sachs has nearly a 7% impact on the Dow.

Huh?  

So, when the US dollar or interest rates move up or down, Goldman Sachs and Visa (and other financial companies – JP Morgan, Travelers, American Express) will have a big impact on how the Dow moves (like this morning).
At the other end (the lower priced names), General Electric, one of the only companies with a true ‘industrial’ component, has a measly 1% impact on the Dow.

It just doesn’t seem right any longer.  We wonder how relevant the Dow Jones Industrial Average is in 2015.

Here’s where it gets even goofier:
Goldman Sachs may have a higher stock price, but the market capitalization is $84 billion.  General Electric, with a much lower stock price (and thus, a MUCH lower impact), has a market capitalization of $257 billion. Why should that be?