The end of an era in the stock market 1

July 23rd, 2008

Indexes were created in order to evaluate trends in the financial markets. Index is a magic word most share market traders use, but very few can tell what an Index is, what are its components, and how is it being calculated. Most investors know just that if the index rises, it is a good sign and vice versa, if the index drops it is a bad sign. The true and full meaning of this term remains a mystery. Some investors, for example, also understand that if an index such as the Dow Jones Industrial declines by more than 20% it is considered a bear-market.

An analysis of today’s markets leaves no choice but to conclude that we are in bear market. Since the beginning of the year the Dow Jones index declined by more than 16%; in the past 12 months it declined by even higher percentage points. A similar conclusion can be reached when we realize that the NASDAQ composite index  plunged YTD (Year-to-Date) by more than 12%. Thus the questions have to be asked: Are we really in a bear market?  Is global economy facing a recession?  I personally doubt the above conclusions and feel that it is the “cross-sector” indexes which create the unfavorable impression.

I would like to avoid getting into complex explanations of how an index is calculated and what do deviations mean, only to suggest that indexes should not be used when trying to make a wise investment decision. For example, the importance of banks and other financial institutions is relatively high when calculating a cross-sector index; this may lead to a distorted assessment of the economy if one looks only at the index, when the value of banks drops aggressively due to various reasons (as it happened recently due to the sub-prime mortgage crisis).

As previously mentioned the Dow Jones Industrial index lost more than 20% in recent months (16% in 2008), the NASDAQ composite is down 18% from its high value, and all these happened while the major financial institutes index lost 70% (!!!!) In the past 12 month. On the other hand the AIG Commodities index GAINED 25% YTD and energy indexes show more than a 30% GAIN, precious metals are  up 5%, Transportation index  up 5%, and the utility index remained flat.

The simple conclusion is that cross sector indexes do not have significant value and do not give a lot of valuable indication to investors. The experienced stock market trading investor should look mainly at indexes which represent specific sectors and even here to be very observant (the transportation index is composed from land transportation, oceanic transportation and airlines, each behaves differently). Mixing various sectors of the economy into one index may lead to erroneous conclusions about the health of the economy.

While as said above the cross sector indexes are sub-optimal in determining the status of the market, many investors are influenced by them and make buy/sell decisions according to these numbers. As we know, emotions do play a significant role in a price of a stock thus while financially an index may be not important, it may lead to a change in a tendency to buy or sell and therefore affect stock prices.

Shimtom
( Satisfied www.yalicoo.com player)

Entry Filed under: Stock Trading Investing Basics