You Can't Judge A Book By Its Cover
By Jud Doherty, CFA
401k Toolbox
Nearly 18 years ago, Loyola Marymount basketball star Hank Gathers tragically collapsed and died during a basketball game. Hank was a gifted athlete in seemingly superb physical condition. During the 1988-89 season, he became the second player in history to lead NCAA Division I in scoring and rebounding in the same season, averaging 32.7 points and 13.7 rebounds per game. On March 4, 1990, he collapsed with 13:34 left in the first half of a West Coast Conference tournament semifinal game against Portland, just after scoring on an alley-oop dunk that put the Lions up 25-13. He was declared dead on arrival at a nearby hospital. An autopsy found that he suffered from a heart-muscle disorder, cardiomyopathy.
Similar fate fell upon professional ice skater Sergei Grinkov, who died suddenly of a heart attack in 1995 while rehearsing for a "Stars on Ice" tour. He was only twenty-eight years old at the time. A sudden heart attack also claimed the life of NHL veteran and Nashville Predators center Sergei Zholtok at the age of thirty-one. While the passing of professional athletes receive the most press, this type of tragedy frequently happens in our country to seemingly healthy high school athletes.
Like me, I presume the first reaction most people have when hearing about such tragedies is "how could this possibly happen to someone who was in such great shape?" While these athletes were young, physically fit, and from all external appearances healthy individuals, internally they suffered from an undetected disorder that cost them their lives. This dichotomy of outward physical appearance and actual health is a great parallel when analyzing the health, and ultimately the risk, of the stock market.
The "outward appearance" of a stock is its price. Unfortunately price is a great indicator of the value of a stock if you sell it right now, but it is a horrible indicator for what that stock might be worth in the near future, or the risk in continuing to own it. To really understand the downside risk of a stock, you need to look beyond the price. How is the company's financial condition, what is the competitive environment, how fast are they growing, etc., etc. An oversimplified example is Enron. The stock price of Enron was the envy of Wall Street prior to its collapse at the end of 2001, when it was revealed that its reported financial condition was sustained mostly by institutionalized, systematic, and creatively planned accounting fraud. The rapidly rising stock price of Enron simply did not provide any indication of the tremendous potential risk.
The "outward appearance" of the stock market as a whole is best gauged by a market index, such as the S&P 500 or the NASDAQ. These indexes, which are widely referenced in newspapers and news reports, provide a summary of the value of the stock market, but like individual stock prices, provide very little help in measuring the risk of the stock market. Technical analysis, the basis for our active account management philosophy, provides an objective way for us to measure the internal health of the market.
Consider the price performance of the S&P 500 Index during the late 1990's. The S&P 500 closed in 1999 with a 21% annual return, marking the 5th consecutive year of returns in excess of 20% per year (a feat never before achieved in the stock market). All seemed well in the world, but a look under the hood revealed a much darker reality. Market breadth, or "advances vs. declines" was deteriorating (the number of stocks declining was increasing, and the number of stocks advancing was decreasing). Other "internal" measures of the market such as new highs and new lows were deteriorating as well. Over the next three years, investors who ignored the internal picture of the market suffered losses not seen since the great depression.
The current bull market is closing its 4th year. By historical standards this bull market is getting long in the tooth, but more importantly, the internal picture of the market shows an increasing level of risk. Our dominant index indicator has switched to the NYSE (historically most bad markets occur when the NYSE is dominant), and our underlying risk measures have begun to deteriorate. We are not predicting a bear market, but we recognize that the risk level has increased and we are prepared to act accordingly.
* Source: 401k Toolbox
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