Index Prices Can Give False Bull Signals

By Chris Marasco - October 19, 2012 | Tickers: KRFT, QQQ, SPY, DIA, UNH | 0 Comments

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I have been intrigued by the decision of the Averages Index Committee – the team that selects the component blue chips for the Dow Jones Industrial Average – to drop Kraft Foods (NASDAQ: KRFT) and replace it with UnitedHealth Group (NYSE: UNH). 

Kraft’s market cap runs just under $70 billion, while UnitedHealth’s is $56.3 billion. The committee decided to cut Kraft because the latter is downsizing – the snacks giant is spinning off its North American grocery business.  Dropping a consumer food company in favor of a healthcare company shows the attention that the world is paying to the healthcare sector, especially since health care reform.

The switch will no doubt bring changes to the index, and it brings up an important point: investors should understand how index prices are calculated. 

When an index rises, the higher price reflects the compenent stocks.  However, some stocks have higher weightings in the index than others, which can give false bullish or bearish signals to investors.  For example, the NASDAQ reached levels that haven't been seen since the tech bubble.  Does this mean that the economy is in full swing, or does it mean that just a few stocks carried the entire index all the way up?

Understanding the make-up of each index and how its component stocks affect the overall price is an important concept that every investors should understand.  Below, I have walked through the Dow, the S&P 500, and the Nasdaq to demonstrate how just a few strong price moves can give the false impression of a rising bull market.

Dow Jones Industrial Average

Tradable ETF: SPDR Dow Jones Industrial Average ETF (NYSEMKT: DIA), also called “the Diamonds”

The DJIA is price-weighted.  Here is a theoretical example of a price-weighted index:  

Imagine that there are 10 stocks in an index.  Eight of them trade at $10 per share, and two of them trade at $40 per share.  The math works like this:

8 x $10 = $80

2 x $40 = $80

Total: $160

The total value of the index is $160.  Note however, that two of the 10 stocks control half of the index’s movement.  If these two stocks were to jump 10% in one day while the other eight held constant, the new value would look like this:

8 x $10 = $80

2 x $44 = $88

Total: $168

Total Gain: 5%

It is for this reason that the Dow selection committee is loath to add a company like Apple or Google to the index.  The tech giants’ exorbitant prices would rule over the index, and the committee would likely have to change the way the index is calculated.  So, when you look at a major jump or drop in the Dow, check to make sure that the move is not the result of a small handful of volatile stocks.  Price-weighted indexes, however, work very differently.

S&P 500

Tradable ETF: SPDR S&P 500 ETF (NYSEMKT: SPY), also referred to as “the Spyders”

In contrast to the Dow, the S&P 500 is market-cap weighted, meaning that index values are assigned based on the total value of the underlying companies.  A firms’ market-cap equals its price per share multiplied by total shares outstanding.  As of August 30, 2012 the S&P 500’s top 10 holdings represented 21.12% of the total index, with Apple commanding 4.88% control.

Using fictitious numbers and Apple as an example, here is how the S&P 500 moves:

Apple Total Market Cap: $1 Trillion

S&P 500 Total Market Cap: $16 Trillion

Apple’s Weighting: 6.25%

Assume that Apple shares jump from $700 to $750, a rise of 7.14%, and all other 499 stocks stay constant:

Apple Total Market Cap: $1.0714 Trillion

S&P 500 Total Market Cap: $16.0714 Trillion

Apple’s Weighting: 6.67%

S&P 500 Percentage Increase Caused by Apple’s 7.14% Increase: .45%

A .45% move is material, and it can trigger stop losses or losses for short-term traders, futures traders, and options traders.

Scary, isn’t it?  Remember that the numbers are theoretical, but they go to show just how much the S&P relies on only a few strong component stocks.  In aggregate, Apple, Microsoft, and IBM make up 8.45% of the S&P 500. Consider – what would happen to the markets if the tech sector dipped?  For this example, let’s look to the tech-heavy NASDAQ 100.

NASDAQ 100

Tradable ETF: Powershares QQQ Trust (NASDAQ: QQQ), called “the Q’s”

The NASDAQ is a market-capitalization weighted index, just like the S&P 500.  However, it does have a few unique caveats:

• Includes the 100 biggest companies in the Nasdaq
• Does not include financial companies
• Includes firms incorporated outside the U.S.

The Nasdaq 100 is even more concentrated that the S&P 500, with the top 10 holdings representing 57.29% of assets as of August 30, 2012.

Here is an illustration from Yahoo! Finance:

What’s the big takeaway here?  Apple’s, Google’s, and Microsoft’s share prices make up one-third of the Q’s price movement.

Say, for example, that you are long the QQQ's, and you have a stop loss that is triggered when you lose 2%.  If Apple experiences some bad news and its stock drops 10.13% - but all other stocks stay exactly the same - you will be stopped out of your position.  Your risk was not distributed evenly across the entire Nasdaq - rather, almost 20% if your risk was tied only to Apple's share price.

Conclusion

Trading Kraft out of the Dow Jones in favor of UnitedHealth Group reminded me of two important items.

First, it shows the growing importance of healthcare companies in the United States.  Healthcare represents a major market, especially with 7,000 – 10,000 baby boomers turning 65 each day, and its significance will only increase as the U.S. looks for ways to trim is massive healthcare spending.  The move will see United Health's $56 share price in the index instead of Kraft's new $27.50 Mondelez International.

More importantly, however, it reminded me just how much control a few companies have over the price of the major indexes.  So much so that buying the Nasdaq 100 has become synonymous with buying one-fifth of a share of Apple.

The next time you place an equity, futures, or options trade, be sure to look for major volatility in the most prominent underlying stocks.  Otherwise, one bad earnings announcement could ruin your trading day.

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