Assume you're at a party, and everyone in the room is drinking punch. You decide to have some as well. But when you get to the punch bowl, it's empty. And every time you return to the punch bowl thereafter, you experience the same. Who could blame you for feeling a bit frustrated?
Now you know how many investors felt during the spring. From April through the middle of July, the Dow Jones industrial average and Standard & Poor's 500 Composite Index were posting all-time record highs, while the broader market, as measured by the advance-decline line, was trending perilously lower.
"Investors were beginning to think something was wrong," recalls Max Erickson, a rep with regional D.A. Davidson in Havre, Mont.
Something was wrong. The stock market was breaking down, even though the shares of some of America's most popular companies (blue chip corporations) were holding up just fine, thank you. It wasn't the first time veteran investment professionals had seen this phenomenon.
In the early 1970s, the country's largest companies, then known as the "Nifty Fifty," were flying high, while the rest of the market was crumbling. And then came the bear market of 1973-'74, which sent the stock market on an agonizingly prolonged slide of more than 50%. Investment professionals who worked during that painful period remember it as one of the most gut-wrenching experiences in their careers.
"It was like Chinese water torture," recalls Gail Dudack, the chief investment strategist at Warburg Dillon Reed in New York who served as a research analyst at a brokerage firm back then. "As easy as it was for the market to make new highs over the past few years, that's how difficult it was for stocks to gain ground back then."
The market of the early '70s also exhibited a falling advance-decline line for about six months before the bear market began. That happened even as the Nifty Fifty carried the averages ever higher. Moral: "You need to focus on what is going on beneath the surface of the popular benchmarks to understand what is taking place in the overall market," explains Larry Wachtel, a market analyst at Prudential Securities in New York who has worked on Wall Street for more than 30 years.
The Dow Jones industrial average, though widely followed by the media and investors, only includes 30 stocks. Broader indexes like the S&P 500 have substantially more stocks. But even then, the biggest 50 stocks in the S&P 500 are responsible for roughly 80% of the market's performance. Just seven stocks account for approximately 25% of the Nasdaq Composite's performance.
Wachtel doesn't feel there is much of a parallel between today's shaky market and the bear market of 1973-'74. "Back then, we had inflationary pressures weighing heavily on stock prices, largely due to rising oil prices, " he says. "Today, the market is more concerned with the threat of deflation than the prospects of higher inflation due to the Asian economic and currency crisis."
But it's still nice to be somewhat prepared for market setbacks, whether they're just corrections or full-fledged bear markets. Weakening breadth, as measured by the advance-decline line, can be one tip-off (see charts in magazine).