Saturday, June 30, 2007

Where to Find a Stock Picking Edge

Quick: Which of the following statements is true:

a) The S&P 500 Index is trading above 1500, making up its losses from the 2000-2003 bear market.

b) The S&P 500 Index is trading near 3000, recently hitting all-time highs and trading well above its 2000 highs.

As we see above in the chart from the highly recommended Decision Point service, both statements are true. The standard, weighted version of the S&P 500 Index ($SPX) is trading above 1500, near its 2000 highs. The unweighted S&P 500 Index, however, has nearly doubled the performance of its weighted counterpart, and its relative strength (bottom panel) has been in a long-term uptrend.

The stock picking edge in the S&P universe hasn't so much been in whether you're invested in one sector or another. Rather, the big edge has come from being in the smaller, lesser-known names. The highly visible mega-cap issues, the favorites of institutions due to their liquidity, have dramatically underperformed their smaller counterparts.

Indeed, if we limit our view to the S&P 100 Index ($OEX), we find that the unweighted version has more than doubled the performance of the standard, weighted index since 1999. And the unweighted NASDAQ 100 Index ($NDX) has outperformed the weighted version by 2-1/2 times over that period.

Quite simply, the largest, most visible names in the stock index world have been the worst performers. It's the stocks that are not on the radar of most watchlists that have enjoyed the stock picking edge.

Interestingly, the dynamic between weighted and unweighted indexes appears to occur at very short time frames as well. Going back to 2004 (N = 877 trading days), we find 139 relatively flat occasions in which the S&P 500 Index (SPY) has been up by .10% or less and down by -.10% or more in a single trading session.

When the unweighted S&P 500 Index (RSP) has outperformed the flat SPY (N = 72), the next two days in SPY have averaged a gain of .15% (42 up, 30 down). When RSP has underperformed the flat SPY (N = 67), the next two days in SPY have averaged a gain of only .03% (35 up, 32 down). The health of the smallest S&P 500 components appear to be related to the index's near-term prospects.

Over time, markets reward prudent risk assumption. In relative terms, the safest, bluest chip stocks do not receive these rewards.


RSP and SPY: Unweighted and Weighted S&P 500 Index

The Safest Times to Trade Offer the Least Rewards