Trader’s Narrative

According to a June 1st press release from Dow Jones: “The Travelers Companies, Inc. (TRV) is taking the place of Citigroup, Inc. (C) and Cisco Systems, Inc. (CSCO) is going in for General Motors Corp. (GM).”

The changes will go into effect on the opening of trading next Monday - June 8, 2009. The last time the Dow Industrial Average was changed was about a year ago when Bank of America and Chevron (CVX) replaced Altria (MO) and Honeywell (HON) (Dow Jones Technical & Fundamental Analysis)

There is an ongoing debate between ‘passive’ vs. ‘active’ portfolio management. Very few money managers are able to beat wide indexes over time. But when you think about it, we don’t really have passive portfolios. If the Dow was truly passive it would still be comprised of companies like Standard Rope & Twine (a component from 1898). But obviously, such an index would have long ago ceased to exist; just like its component companies. To continue to exist and be relevant, an index must evolve along with the stock market. And that makes it an actively managed portfolio.

The only real difference is that a ‘passive’ investment portfolio like the Dow Jones has a much lower turnover rate than more actively traded portfolios managed by you or a hedge fund trader or a mutual fund portfolio manager. So the debate is really about turnover. When you start to buy/sell at a furious pace, not only do you have to deal with transaction costs but shrinkage due to spreads, errors and taxes. Unless you have an edge that can beat those costs, you’re trying to get out of a hole by digging faster.

The funny thing is that although these index changes are necessary, most of them result in lower performance. There have been a lot of studies done on indexes like the Dow and the S&P 500 which show that in the short term, companies that are removed provide higher returns than those which they were replaced by. Which means that GM (GMGMQ) and Citigroup (C) are probably going to outperform Cisco (CSCO) and Travelers (TRV) going forward. So the price that you pay for having an index like the Dow or the S&P 500 continue indefinitely is that their performance is actually lower than it would be, had there been less interference with their composition.

Ah Sunday, a perfect time to catch up on what you missed and to prepare for next week. (Right after you mow the lawn.) Here are just a few choice readings from the past week’s list at news.tradersnarrative.com.

• Top 10 Questions for Buffet from Jeff Matthews blog, Not Making This Up
• Comparing Sentiment During This Rally & Past New Bull Markets
• Get a 120 page report FREE from Global Market Perspective (limited time offer)
• Why the Market Should Thank Obama
• The Market Doesn’t Have to Be Fair - Lesson From DNDN
• Ideas Trump Crisis: Lessons From 1929
• Tech Stocks Are Coiling for a Breakout
• Conde Nast Shutters Portfolio. Why It Failed
• Who sez there’s “no free lunch”? Get a Free Subscription to Futures Magazine
• 25 Years to Bounce Back? Try 4½

Follow the link below to get much, much more:

And remember to check regularly since there are new links added everyday.

Week Ahead: Capitalism’s Woodstock

Book Giveaway
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Hedge Fund Operational Due Diligence (follow link and submit comment)

For obvious reasons, the current bear market has been relentlessly compared to the previous one that we lived through just a few years ago. But while a long term chart of the S&P 500 Index (SPX) would suggest, through a massive double top formation, that the two are similar in scope, that isn’t really the case:

In fact, if we look at the stock market as would the the average investor, we find that the average “Joe” has lost much more money in this bear market than the last.

That’s because no one really allocates their portfolio according to the capitalization of the stocks they are buying. Instead, they buy a smattering of mutual funds, individual stocks, sector ETFs, etc. So a more accurate representation of this “average” portfolio is the equal weight indices. For example, as represented by the Rydex S&P 500 Equal Weight (RSP) ETF:

Although the chart above is for the ETF, it is confirmed by the more widely used equal weighted index, the Value Line Arithmetic Index - a much wider index with 1700 individual constituents. It has also fallen approximately 60% in this bear market.

The other interesting aspect of the market that we see through this chart is that in both cases, capitalization weighted and equal weighted, price has approached (and seemed to have bounced off) support.