A Two-Tiered Market Gives Valuable Clues
By Rev Shark
RealMoney.com Contributor
5/7/2007 8:40 AM EDT
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"Sometimes a majority simply means that all the fools are on the same side."
-- Claude McDonald
The biggest problem that market players face right now is that "everyone" knows that we are due for a rest. No reasonable investor can contemplate the recent run in the DJIA and not think that some sort of pause or pullback would be a good thing. We all know that the market moves in cycles and the present cycle is becoming old.
Of course, when "everyone" believes the same thing, it is less likely to happen because they have already acted on their belief. If "everyone" believes the market is going to rest, then many have already acted on that belief, which means there is less unused selling potential to make it occur.
The problem with this rather simplistic analysis of sentiment is that we really have a two-tier market right now. Most of the market is not nearly as strong as the major indices would indicate; it is the mega-cap stocks in the DJIA that have given the impression that the market is becoming extended. Many market players have missed out on that move and hence are not feeling the exurburance that the indices seem to indicate.
Since May 3, 2006, the S&P 500 is up 14.9%. During that same period the stocks in the Investors Business Daily Top 100 are up 3.1%. This is the first time in the years I have been trading that anything like this occurred. Typically in a strong market it is the IBD stocks that have tended to lead.
These are the stocks with very strong earnings growth and good relative strength. Typically in good markets aggressive investors will flock to these stocks because they make bigger and quicker moves than the mega-cap Dow-type stocks.
I believe the underperformance in the IBD-type stocks is why sentiment has remained so sedate even as the indices keep hitting new all-time highs. The average aggressive investor simply isn't participating. He is holding things like GOOG, which hasn't done anything over the past year or so, rather than a Coca-Cola, which is up 20%-plus.
The big question is, how does this resolve itself? Can it persist for much longer? It certainly wouldn't seem that way as the big-caps become increasingly expensive on a comparative basis. We are already seeing the laughable notion that many of the mega-caps are still cheap because they are selling at PEs only twice their growth rate. Sooner or later valuation will be stretched enough that liquidity will be less of a driving force.
So do the IBD-type stocks accelerate and catch up to the big-caps, do the big-caps correct downward, or do we see some combination of the two? I don't know the answer but being keenly aware of that question will be very helpful as we move ahead. Something in the character of this market has to change because it is becoming increasingly narrow and relative valuations are becoming unreasonable.
We have a quiet start to the week. There are some more mergers and acquisitions on the wires once again but the mood is relatively contained. The big news this week is going to be the FOMC interest rate decision on Wednesday at 2:15 p.m. EDT. No one is expecting the Fed to make any interest rate changes but the accompanying policy statement is going to be a market mover.
