Will The Negative Correlation Between The NASDAQ And Dow Continue?

By: Kent Engelke | Capitol Securities

Is a great rotation at hand? Since the June 8 House repeal of Dodd Frank, a major rotation may be in its nascent stages. Yesterday, I commented about the volatility in the NASDAQ 100 since the repeal, the greatest volatility as compared to the market since 2002, commenting the average NASDAQ stock is down about 12% from its annual highs and 15% of its members are in a bear market—defined as a decline of more than 20% from its annual highs.

Yesterday’s WSJ expanded on this potential rotation. The Journal wrote the typical close relationship between the Dow Jones and the S & P 500 has broken down stating the 20-day correlation between these two major yardsticks fell to 0.47 or the lowest since 2003.

The Journal writes the major difference in composition between the Dow Jones and the S & P 500 is that the Dow is price weighted, meaning that companies with the highest stock prices carry the most sway. According to Dow Jones, Goldman trades around $225 share, representing its biggest holding. Industrial stocks account for one fifth of the Dow.

Contrasting the Dow Jones composition to that of the S & P 500, which ranks stock by market value, Apple is the largest company in the world and is the S & P 500’s biggest holding. Goldman is ranked 52nd according to the WSJ.

The Journal finally writes the 20-day correlation between the Dow and the tech heavy NASDAQ composite is a minus 0.45, the weakest since 2001. This means the two averages are moving in opposite directions. Over the past 15 years, these two benchmarks have a correlation of 0.83.

Many times I have commented about the unbalanced markets, the result of the massive proliferation of capitalization based ETFs and HFTs. I further postulated a disparity between the performance of “value stocks” and the largest momentum growth technology stock could develop, defined as value outperforming technology for the first time in many years.

Twenty days do not make a trend, but a major reason for the recent divergence between value and growth is surging financials, the result of the House’s repeal of Dodd Frank.

Financials account for the lowest percentage capitalization of the S & P 500 in at least 15 years. Oil is the lowest since 2000. Will the divergence continue?

I believe it will be dependent upon earnings. Some of the largest financials report profits this week.

Historically the outperformance of financials indicate an accelerating economy (A strong economy increases the likelihood of loan repayment). Is the recent bout of weakness in the Treasury market confirming the possible acceleration? One month ago, the 10-year was at its annual low yield of around 2.10% with many pontificating a “one handle” is all but a certainty. Today, the yield is about 2.40%.

The newswires are filled with stories about the death of macro investing, a strategy based upon a geopolitical and macroeconomic thesis, replaced by passive indexing and ETFs. This death process commenced about 12 years ago with the advent of ETFs, accelerated by the 2008-09 financial crisis, had a short reprieve from 2011-2013, but went into a spiral following the full implementation of Dodd Frank in September 2014.

Perhaps a Bloomberg graph illustrates the outsize impact that ETFs or capitalization weighted passive investment strategy has had upon assets in the market. In 2004, the amount was insignificant. Today there is over $3 trillion in ETFs.

Many years ago, the equivalent of the Warren Buffet of that era once commented when everyone is doing something, an end is near. Mr. Bessemer also stated passive investment outperformance does not last forever, for if it does, all would be very wealthy.

Last night the foreign markets were mixed. London was down 0.84%, Paris was down 0.24% and Frankfurt was up 0.10%. China was down 0.30%, Japan was up 0.57% and Hang Sang was up 1.48%.

The Dow should open nominally lower ahead of the commencement of second quarter earnings and Yellen’s congressional testimony about the economy later in the week. The 10-year is off 2/32 to yield 2.38%.

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