Weekly Note - June 19, 2024

 Divergence Now, Convergence Later

Last week’s note discussed how the “cap-weighted” construction technique used in the S&P 500, NASDAQ, and many other stock indexes causes them to become more heavily concentrated in stocks that have done well. Generally, they place heavier weight over time in stocks that have had higher price gains. They reduce weight over time in the stocks that have performed relatively poorly.  This tends to be the opposite of what we want to do as investors, which is to buy low and sell high. Thus, the cap-weighting construction of these indexes results in them having a more prominent boom-and-bust performance pattern.

The DJIA does not use this weighting scheme; it uses a scheme that gives each stock a more stable weight over time. This stable weighting scheme is one of the key reasons we make extensive use of the DJIA. The company that manages the S&P 500 (ticker SPX) also has an equal-weighted index called the S&P 500 Equal Weighted (SPW).  Adoption of the SPW has been slow; it is not often mentioned in the press.   

The stock for NVIDIA has returned almost 150% this year. Its strong performance is related to its role in AI. With its strong performance, it is having a big impact on cap-weighted indexes and related ETFs. 

The figure below shows the return for 2024 through last Friday of the cap-weighted indexes S&P 500 (SPX) and the NASDAQ-100, which both hold NVIDIA.  It also shows the S&P 500 Equal-Weighted index (SPW), which holds NVIDIA at the same weight as the other stocks it contains, and the DJIA, which does not hold NVIDIA. 

The image is one of stark divergence, with the cap-weighted indexes performing much better than the more equal-weighted.  By design, we have both types in our portfolios with higher weight in the more equal-weighted DJIA because we want to avoid the boom-and-bust patterns. Our strategy is to gain most of our returns using leverage to magnify the returns of the DJIA rather than to depend exclusively on cap-weighted indexes for returns. We participate in the themes present in the NASDAQ but we have a lower maximum target weight for the related ETF. 

Right now, our target weights reflect the divergence shown above.  We hold more NASDAQ and less DJIA. 

Going forward, the two types of stock indexes are likely to converge.  There are two general scenarios to convergence.  The first is that the NASDAQ will drop toward the DJIA. This would take place if investors conclude that the price of AI-related stocks has moved up too far and needs to drop to more reasonable levels. This scenario may involve the DJIA moving lower and the NASDAQ moving lower as well. The second scenario is that the DJIA will gain to catch up to the AI-heavy NASDAQ. Of course, there may be a combination of these two scenarios.   

While our models do not explicitly indicate right now which scenario is more likely, we can see the MRI dynamics of the NASDAQ and they suggest divergence may last at least a few weeks more.  As of last Friday, the resilience conditions for NASDAQ were (see this page for a discussion of terms: https://focused15investing.com/language):

    Macro MRI: 48th percentile since 1972. This is midway in its normal range. 

    Exceptional Macro: Not present.  It ceased to be present April 19, about two months ago.

    Micro MRI: 53rd percentile. Again, midway through its cycle

This means that the NASDAQ currently has two of the three MRI in the uplegs of their cycles.  The Macro MRI can move much higher from here, since that MRI is only midway through its normal range. 

Regarding the NASDAQ’s Micro MRI, it was at the 53rd percentile last week.  In normal markets, the Micro MRI moves up about 12 percentile points a week. This pace suggests that it will be high in its normal range (about the 80th percentile) in about 3 weeks, approximately July 5th.  Unless the Exceptional Macro reappears before then, the end of the upleg of the Micro MRI would be a reasonable time for the NASDAQ to pause and possibly move lower; the NASDAQ will then have just one of the three MRI providing resilience. 

Our research on the naturally occurring shifts in sentiment supports this general timeframe for weakness in the stock market. The natural shifts indicate that a period of naturally occurring vulnerability began late-May and vulnerability will accelerate beginning mid-July. Thus, if a price decline needs to happen for economic reasons, it is likely to take place between now and mid-August.  This suggests that if the NASDAQ does need to drop in price, it is more likely to do so before mid-August. If the NASDSAQ does not drop to converge with the path of the DJIA by then, the DJIA may then move higher toward the path of the NASDAQ. 

In terms of valuation, both the DJIA and NASDAQ have high price/book and price/sales ratios.  These ratios are above the 90th percentiles for both indexes and have been for several quarters, suggesting that price declines for the NASDAQ and the DJIA may be needed. 

Of course, we will respond to any changes indicated by the algorithms before then.