TimingCube - Equal weight ain't equal - Dow Jones Industrial Average, equal weight ETFs, stock performance

Signal Type

Trade Date

Return since issued

World

U.S.

Nasdaq 100
(QQQQ)

Russell 2000
(IWM)

S&P 500
(SPY)

Market Update

The ongoing rally shows no sign of abating, as stocks moved higher again this week, even though the gains remained modest compared to those of the previous two weeks. The government said Monday that new-home sales rose an impressive 11% in June, marking the best monthly change since 2001. It was the first of several positive news that point to a strengthening economy. Indeed, the Federal Reserve acknowledged in its beige book that economic activity in many U.S. regions is beginning to stabilize, before the Labor Department reported Thursday that weekly jobless claims dropped to their lowest level in 6 months. GDP numbers also came in better than expected as the economy only contracted at an annualized rate of -1% during the second quarter, a marked improvement over the -6.4% corresponding reading for the first three months of the year. The brightening economic picture gives ammunition to the bulls. With more investors now in buying mood, the S&P 500 finished the week at its highest level of the year. The index also gained 7.4% during the month, which marked its best July since 1997.

The Russell 2000 (IWM), S&P 500 (SPY) and Nasdaq 100 (QQQQ) respectively gained 1.39%, 0.76% and 0.25% over the five-day span. All three ETFs are located above both their 50-day and 200-day exponential moving averages (EMAs).

For its part, our World portfolio posted a 0.18% gain this week. The portfolio consists of the 5 top-ranked world ETFs as of July 17, which marked the beginning of the current 4-week holding period.

Our current Buy signal remains in effect.

Trend Timing School

Equal-weight ain't equal

We consider there to be two broad keys to success when investing in stocks:

Protect your capital during weak markets
Maximize your gains during strong markets

The TimingCube signal offers us the ability to protect our capital (and even profit!) during weak markets. With that base covered, we consider how to maximize our gains when the market is healthy. We publish the results of the TimingCube signal as applied to broad domestic indexes: the S&P 500 , Russell 2000 , and Nasdaq 100 . You can look at our "Results" page for historical comparisons of these three broad indexes. Generally speaking, the higher risk Nasdaq 100 and Russell 2000 will offer the better returns. Outside the domestic indexes, we commented in a recent weekly update that applying our signal to emerging markets provided very handsome results. With our World Index rankings, we take that one step further by providing another set of investment choices - the best performing country ETFs. In this weekly update, we suggest yet another investment choice for consideration - equal weight ETFs.

Launched in 2003 by Rydex Investments, equal weight ETFs provide an alternative to investing in basic sector or index ETFs. Most ETFs are weighted by their size in the stock market (aka their "market cap" which equals their number of outstanding shares multiplied by their stock price). This gives the largest companies a very high proportion of the index and therefore a substantially greater influence on price than the smaller companies. For example, the top 10 largest companies in the S&P 500 account for 20% of the index value. Thus, a 5% move in Microsoft (the second largest holding in the index) has 10 times the impact on the price of the S&P 500 as a 5% move in General Mills. For investors, the implications are that the indexes are significantly beholden to the performance of the largest companies.

Coming out of most recessions it is the smaller companies that exhibit the best stock performance. Indeed small cap stocks are historically the best performing group of stocks, period. It pays to invest in smaller companies as they possess the fastest earnings growth rates which often fuels faster stock price appreciation. Equal weight ETFs offer investors a chance to benefit from smaller companies while not abandoning the benefits of the larger companies. For example, the equal weight technology ETF (symbol: RYT ) simply gives Intel and Broadcom the same weight (roughly 1.5%) in the ETF whereas Intel comprises almost 5% of the regular technology sector ETF (symbol: XLK ) to Broadcom's 0.6%.

Let's take a look at the performance of equal weight ETFs from the beginning of the market's rally in March. Along with technology, consumer discretionary stocks have been a leader of the market's advance. You can see the fairly significant outperformance of the equal weight ETF fueled by the higher percentage gains from the smaller companies. This relationship holds true for almost all sectors, with the equal weight showing a healthy performance benefit.

Chart 1: XLY and RCD from March 2009

Reviewing the prior bull market cycle from 2003-2007, we see the same phenomenon: outperformance by the equal weight ETF. Here is the performance comparison of one of the leading sectors of that bull market: energy stocks.

Chart 2: XLE and RYE for 2003-2007

Buying the S&P 500 index would normally be considered an investment skewed toward larger companies as described above (20% of the index being in 10 very large companies). Using the equal weight S&P 500 ETF, however, you are buying the S&P 500 but getting far more exposure to smaller companies. The chart below shows the dramatic benefit of investing in the equal weight S&P 500 ETF (symbol: RSP) through the last bull market and even in a buy and hold approach since the beginning of this decade. Note that the volatility of the equal weight S&P ETF is about 20% greater. But the improvement in returns is consistent and substantial during uptrending markets.

Chart 3: RSP and SPY from 2000+

In summary, accelerating performance during bull markets is a key to growing our wealth. We can achieve that by choosing the best sectors, best countries, best indexes, or by using leveraged ETFs to give our portfolio an added boost. By using equal weight ETFs, however, we are often getting outperformance while taking less risk than any of those other choices. The caveat with equal weight ETFs is that some of the daily volumes are very low. Thus, you MUST use limit orders to buy and sell.

Equal weight ain't equal after all; it's far greater! Enjoy your gains.

FAQ of the Week

Question: Is the Dow Jones Industrial Average relevant?

Some recent market commentators suggested that investors ignore the movements of the Dow Jones Industrial Average, saying that the index was "irrelevant". Why this trash talking of the Dow? The Dow Jones Industrial Average (DJIA) is by far the eldest of the indexes, with roots dating back over 100 years to Charles Dow's introduction of the index in 1896. The DJIA attempts to use 30 stocks as a proxy for the U.S. stock market. It does not include transport or utility companies. With only 30 companies, it is hard to argue that the DJIA offers a better view of the broad market than the 500 companies in the S&P 500, or the thousands of stocks captured in the Wilshire 5000 index. But the Dow's largest shortcoming could be its reliance on a unique weighting mechanism. The DJIA weights its 30 stocks by price, giving more influence to stocks that have a higher price (adjusted for stock splits). Thus, when Citigroup fell to the low single digits earlier this year, it had relatively little impact on the DJIA. Instead, higher priced stocks like IBM and Exxon have a substantially greater impact, far more so than a much broader line industrial company such as General Electric (the longest tenured member of the DJIA). Almost all other indexes are weighted by market capitalization, which approximates the size of the company far more than stock price alone. Over 100 years later, the Dow Jones Industrial Average remains a fixture in our daily reporting on U.S. stock market activities. Among professional investors, however, the Dow is more of a historic curiosity than a useful measure of true stock market movement.

Warm wishes and until next week.

The TimingCube Staff

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