I am regularly asked why I almost exclusively use the S&P 500 as a "proxy" for the stock market, instead of the Dow Jones Industrial Average (aka "the Dow"). The S&P 500 is the standard among professionals (and many retail traders), but the Dow is better known among novice investors.
There is no perfect average that will reflect the overall market impartially. However, most standard approaches use some weighted average based on market capitalization. That way, the largest and most valuable companies have a greater effect on the index than the smallest companies.
A capitalization-weighted index works fine because the most successful companies tend to have the greatest value. One of the most important drawbacks is that a weighted index can be distorted when one of the largest companies, like Apple Inc. (AAPL), has a particularly good or bad day, which has a disproportionate effect on the index.
Unlike the S&P 500, the Dow index uses a weighting methodology that makes no sense. The 30 stocks included in the index are weighted based on share price, which has nothing to do with market value or growth. That means that, if the highest-priced stock in the index, The Boeing Company (BA), is having a bad day, it will overwhelm the performance of Pfizer, Inc. (PFE) which has a nearly identical market capitalization as Boeing but a share price of $41.25 vs Boeing's at $395.84.
This was exactly the problem this morning when the S&P 500 and Nasdaq indexes opened higher while the Dow was negative. As you have probably seen in the news, two of Boeing's 737 planes have been involved in recent crashes, which resulted in a decline of up to 8% at one point in today's session. Traders are worried about the company's liability, brand and goodwill after these tragedies.
For most fundamental investors, the problems with the Dow's methodology aren't an issue; for technical traders or investors who use index analysis to measure risk and make portfolio decisions, the choice of index is much more important.
Speaking of indexes, the S&P 500 shot straight up today as investor confidence returned. The early rebound seems to have been aided by a higher-than-expected retail sales report. I was frankly a little underwhelmed with the retail data after last month's debacle. I suspect that an adjustment or revision is still coming and should show up next month.
Also contributing to the rally was an announced deal that NVIDIA Corporation (NVDA) will acquire Mellanox Technologies, Ltd. (MLNX) for $7 billion. As I have mentioned in previous issues of the Chart Advisor, academic research shows that large acquisitions and mergers rarely create a positive return. However, they are helpful ways to think about risk- appetite. Acquisitions of this size are risky, and managers and boards tend to only undertake them only when confidence for growth in the near future is high.
From a technical perspective, I am still wary of the 2,800 resistance level on the S&P 500, but last week's retracement could act like the pause at the end of January that was just long enough for investors to refocus on undervalued opportunities and push the market higher. If there is more confirming evidence in the bond market and if the value of the U.S. dollar can ease back off its highs, then the probability of breaking resistance will be higher.
Risk Indicators – A Weaker Yen
Despite the selling last week, there weren't any overt signs of panic, which made today's rally a lot more likely. Except for an overly bullish U.S. dollar (USD), most risk indicators are still low. Even if stocks give up today's gains later this week, if panic stays out of the market, then I will maintain my bullish bias.
One of the indicators that could provide early warning that investors are preparing to push stocks higher and use more leverage is the Japanese yen (JPY). As you can see in the following chart of the USD-JPY exchange rate, the currency has been rejected at its 61.8% retracement level of the recent downtrend. That means the yen got stronger last week while stocks dropped, which is normal.
If the exchange rate rises back through this resistance level (indicating that the yen is getting weaker), then we should expect stocks to rise as well. The correlation between the yen and stocks isn't perfect, but it frequently leads market rallies. For example, it led the stock rally last April by a little more than two weeks. If it happens, I wouldn't expect a breakout like that to occur any earlier than this Friday.
Bottom Line: Trade and Durable Goods
The second week of the month is usually a little quiet for economic announcements. However, besides today's retail report, the durable goods data that will be released on Wednesday morning before the market opens could provide helpful confirmation. Durable goods are those industrial and retail products with an expected life-span of three years or more. A positive durable goods report could offset investor worries about the tariffs – at least temporarily – and help push stocks through resistance.
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