If Dow at 8,000 is artificial, where does this leave the STI?

Business Times - 02 Feb 2009

By R SIVANITHY

SENIOR CORRESPONDENT

ELSEWHERE in this issue of BT (see Hock Lock Siew column) we've pointed out the shortcomings of the price-weighted Dow Jones Industrial Average as a reliable benchmark for the state of the US stock market and economy.

In a nutshell, a big reason why the Dow appears resilient around the 8,000 mark (exactly where it ended after Friday's plunge) is that the index guardians have not removed the stocks which have dropped below US$10, unlike what they did in the past.

For the record, as of Friday, there were four such counters - Citigroup at US$3.55, Bank of America at US$6.58, General Motors at US$3.01 and Alcoa at US$7.79.

Readers would note that these are among the stocks most likely to react to bad news from the banking and auto industries but because they have already crashed to rock-bottom levels, their influence on the Dow is severely limited since the index is price-weighted and all price movements are treated equally, regardless of market capitalisation.

To see how distorted a picture the Dow transmits, take this for example: On Friday, a US$3.72 slide to US$54.50 by the stock of Proctor & Gamble (P&G), which has a market cap of US$163 billion, removed 29.6 points from the Dow, while 3M, with a market cap of just US$37 billion (one-quarter of P&G's), exerted almost the same effect of cutting 22 points off the index because its almost-identically-priced shares fell by almost the same amount - US$2.76 to US$53.79.

Meanwhile, the four sub-US$10 stocks mentioned above all fell, but only contributed a combined total of 11 points to the Dow's final loss of 148 points to 8,000, despite having a total market value of US$86 billion.

Even if one accepts that price-weights are one way to construct an index, the failure to replace the low-priced stocks with higher-priced stocks in the Dow have created the mistaken impression that the index is more resilient to bad news than it actually is.

Speaking of resilience - or rather the lack of it - traders might have noted that Wall Street's January performance was a 7-9 per cent loss for its major indices, not a particularly auspicious portent for those who believe in the old market adage 'as goes January, so goes the rest of the year'.

It might simply be yet another bit of superstitious market folklore with no fundamental grounding, but if Wall Street had posted a January gain, you can bet your last dollar that opportunistic brokers and analysts would have used it to offer hope to the investing public and to urge clients to buy.

The smart money, however, would stick to the two central tenets of investing in this new age of high volatility, low returns and bankrupt US investment banks - 'sell into strength' and/or 'buy in anticipation, sell on news'.

Both have proven effective throughout 2008 and again so far in 2009.

Last week's gains before US President Barack Obama presented his stimulus bill to the House of Representatives, followed by an immediate collapse when the bill was passed, leads us to believe there's no reason to expect any different in the weeks ahead, especially when the news from the US could be mostly negative.

In its report over the weekend, research outfit Ideaglobal noted that the US Conference Board has said the US jobless rate may reach at least 9 per cent by end-2009 and that Q4 inventory buildup does not bode well for current and coming quarters.

'The 'Bad Bank Plan' may be delayed. . .The White House says GDP data shows the crisis in the housing and financial sectors has spread to all areas of the economy', noted Ideaglobal. On Monday, the Commerce Department will release its December personal income and spending report, which is not expected to be encouraging given rising job losses and deepening anxiety associated with the housing crisis. There are also a slew of earnings reports due, which are expected to add to a volatile week ahead.

The trading pattern in the five days to come will follow a by-now familiar pattern, in which the Straits Times Index's direction is set by the Hong Kong market as well as so-called advance programme trades from the US - the word 'advance' suggesting that these trades are to buy or sell STI components before the expected move on Wall Street, not after.

A final thought is appropriate - is the STI's resilience around the 1,700 mark related to traders' belief that the Dow will hold at 8,000? If the latter is based on a distortion that might one day be corrected, where would this leave the STI?