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Market has a new set of rules

Updated: May 3, 2013 12:14PM

Originally published: August 7, 2001

The official statistics say we’re still in a bull market, but we’ve had a “correction.” Does that agree with your own investment portfolio results?

Perhaps some definitions are required.

Officially, a drop of 10 percent or more in the S&P 500 stock index is considered a correction. A bear market requires a 20 percent decline. So, we’re still in a bull market--perhaps one of the greatest bull markets in American stock market history.

If you’re still shaking your head, wondering where your personal bull market is, you’re not alone. It appears that while some stocks are in a raging bull market, many more are participating in their own bear market. But because of the way the averages are constructed, a relatively small group of companies are giving the impression that the popular averages represent the entire universe of stocks.

That’s just not true.

The S&P 500 stock index made headlines by gaining 19.5 percent in 1999--but only 10 issues accounted for 62 percent of the gain. In fact, 80 percent of last year’s S&P gain was produced by only 15 stocks. If you missed those few stocks, you’re probably angry at your broker--or yourself.

Even worse than missing the bull, was riding the bear in the midst of all that bullish shouting. It’s not just that many stocks didn’t rise in 1999, half of the S&P 500 companies ended the year down more than 30 percent from their 1999 highs.

It was a similar story on the Nasdaq, according to Tim Krochuk, portfolio manager of Fidelity’s TechnoQuant Growth fund. Gathering statistics from Barron’s and other sources, he points out that from the Nasdaq low point in October 1998 until the end of November 1999, the Nasdaq gained 241 percent. (That’s before the index spurted over 4,000.)

Yet only 65 stocks out of a universe of more than 4,770 companies in the index accounted for the full 241 percent gain! And fully half of that total gain came from just five stocks!

If you missed owning those companies, you missed most of the bull market. And if your mutual fund missed owning those shares--no matter what the title or style of the fund--it, too, missed the big gains.

That leads to two big problems for investors: How do you pick those winning stocks (or funds), and what about the long-held benefits of diversification?

Picking stocks used to be described as the science of investment analysis. And like most sciences it depended on certain immutable laws or rules that occasionally were distorted by emotion, but which ultimately set a discipline for creating investment gains.

One of the most important rules was: Buy stocks of companies with rising earnings.

Owning a stock is a “claim” on the earnings of the company--not on revenues of the company. It takes earnings to create value for investors. At least that’s the historical definition.

A study by Bob Farrell of Merrill Lynch shows that if you made a portfolio out of all the companies that made money last year, the value of the portfolio fell 2 percent in value. On the other hand, the stocks of all the companies that lost money turned in an average stock-market gain of 52 percent!

Admittedly, that’s an unscientific and unweighted example--but it does show that the traditional rules of investing have been turned upside down.

The second issue for investors revolves around the concept of diversification. Theoretically and historically, dividing a portfolio among different types of stocks (and other assets such as bonds) should enhance performance, while reducing risk.

Yet over the past two years, any portfolio that diversified outside of technology stocks suffered far greater losses. So no matter what the title or style of a mutual fund, portfolio managers have learned they have to be invested in technology to beat their benchmarks--and keep their jobs.

Even worse, those who follow the old rules and tell themselves they’re doing the right thing have lost money as they invested in companies that demonstrate value: had low stock prices and were growing real earnings. But as all the money chases technology stocks, these value stocks have been hammered unmercifully. And just when these value investors think they’ll be proven right, the Nasdaq rebounds from a brief selloff, as it did Wednesday, setting another record--and proving the value investors wrong again.

So here’s what we’ve learned over the past year or two.

Don’t buy stocks with earnings.

Don’t diversify your investments; stick with technology.

There’s an old Savage Truth: The market is always right . . . until it changes its collective mind.

Terry Savage is a registered investment adviser for stocks and commodities and is on the board of directors of McDonald’s Corp. and Devon Energy Corp. Send questions via e-mail at Her third book, The Savage Truth on Money, recently was published by John Wiley & Sons Inc.

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