Sterling Market Commentary for Tuesday February 14th, 2012

 A Look at Yesterday’s Market:  The overall market moved moderately higher in a broad based move that saw the vast majority of the sector indices I track move higher as well.  There was strength in the airlines, Biotechs, Transports, Retailers, Cyclicals, Insurance, Banking, Oil & Gas, Telecom and Commodities.  There was weakness in the Gold/Silver, and Utilities.  In the commodities markets, Oil was higher by $2.24 to $100.91 per barrel, and Gold was lower by $0.40 to $1,724.90 per ounce. In the grain markets, Wheat was higher by $0.112 to $6.412 per bushel, and Corn was higher by $0.076 to $6.394 per bushel, while Soybeans were higher by $0.23 to $12.520 per bushel.

A Few Thoughts on Tuesday’s Market:  In looking at the charts of the various indices I track, I noticed a couple of things.  The 1st being that several of the various sector indices appear to be looking as if they could easily turn lower.  Additionally the Gold/Silver indices continue to look weak.  The second thing that I noticed is that a couple of the high tech indices appear to have gone parabolic with their chart patterns. In effect, they sort of look similar to the chart of Apple, Inc. ‘AAPL’ over the course of the last several months.  The NASDAQ 100 has also been effected by this as well.  This is a result of the way in which these indices are designed.  They are capitalization weighted indices, which means that the ratio, or weighting, of the stocks within the index is based upon the market capitalization of the companies that comprise the index.  I have never been in favor of this form of index construction.  I think it has several drawbacks,  some of which can have very devastating consequences.

I think capitalization weighted indices can create the equivalent of self-fulfilling prophecies when one or a handful of stocks out perform the overall market.  For example as more money is invested in the shares of Apple, Inc. and the market capitalization rise,  then the weighting of Apple within these indices is increased.  As a result of the weighting increase, index funds then increase their holdings of Apple in order to compensate and attempt to match the performance of the index.  This can then increase a circular, self-reinforcement loop; which can also have the effect of accelerating any downside movement during a sell off.

Another less noticed side effect of market capitalization weighting of stock indices is that the other companies within the index see selling pressure on their shares as their weighting within the index is reduced.  While this is probably not an overly dramatic amount, it still is a factor. However, this could very easily be offset by massive amounts of money flowing into these sectors as investors chase the latest hot sector.  In that case it could help create a bubble in that particular sector.

Another of my complaints is that the market capitalization weighting of stock indices distorts the real performance of the stocks within the index.  While it is very obvious how the operations of Apple are currently performing, it is far from obvious how the business operations of the other component companies are performing. I think this distortion can very easily cause a misallocation of capital that is very bad for investors and the overall market.

My suggestion for a potential solution to this problem is to limit the possible weighting a company may have within a particular stock index.  For example one possible solution is within the NASDAQ 100 to limit any particular company to 2%.  For example,  the top 25 companies by market capitalization would receive a 2% weighting, the next 25 companies would receive a 1% weighting, and the bottom 50 companies would receive a 1/2% weighting.  I’ve been kicking around this idea for years.  It is just my idea, and it is something that would be purely voluntarily implemented by the people that run these indices.  But I think it would definitely help smooth out some of the wilder fluctuations and distortions in the some of these stock indices.

With respect to the overall market, I think it looks like we could be putting a short term top in place with the potential for a pullback in the near future.

The Bottom Line:  It is still a dull market, and never short a dull market.