Don't Be Fooled By The 'Breakout' In Stocks

Includes: DIA, EEM, EFA, QQQ, SPY
by: The Financial Lexicon

Over the years, whether in casual conversations or in the media, I've noticed that when someone references "the market," he or she is almost always referring to the Dow Jones Industrial Average (NYSEARCA:DIA). This index, which represents just 30 stocks (well-established, well-recognized companies), seems to be the representation of the stock market in the minds of many Americans and appears to have an impact on the psyche of many retail investors unlike any other equity index in existence.

In recent days, the Dow broke above its 2011 high of 12,876 on an intraday basis as well as its 2011 closing high of 12,810.54. This received a good deal of attention, especially from business television stations. So how should investors view this breakout above last year's highs? While it is impressive that the Dow has managed to recover so strongly from last October's lows, what about the other broader indices? Are they following suit into breakout territory? In fact, there are several big ones that are not, at least not yet.

The Dow Jones U.S. Total Stock Market Index (full cap) is a broad market index that has the objective of representing all equities with readily available prices from companies based in the United States. This index reached its 2011 high on May 2 at 14,501.56. It is currently trading at 14,331.21, 1.17% below last year's high. The NYSE Composite Index, designed to track all common stocks listed on the New York Stock Exchange (including ADRs and REITs), reached its 2011 high of 8,718.25 on May 2, 2011. It is currently trading at 8,114.51, a rather large 6.93% below last year's high. And, of course, we can't forget about the extremely popular S&P 500 (NYSEARCA:SPY). Although it is not as broad as the two indices just mentioned, it still remains a much broader representation of equities than the Dow Jones Industrial Average. The S&P 500 also reached its 2011 high of 1,370.58 on May 2. At the moment, it is at 1,361.23, still 0.68% below last year's high.

I recognize that the Dow Jones U.S. Total Stock Market Index and S&P 500 are within a stone's throw of their 2011 highs. However, given the popularity of the Dow Jones Industrial Average among the investing public as a representation of all things stocks, I think it is important to point out that, in fact, it is not the most accurate representation of the underlying strength of publicly traded equities as a whole. The NYSE Composite, S&P 500, and the DJ U.S. Total Stock Market index help to confirm this. Furthermore, given the incredible popularity in recent years of diversifying into international equities, it is useful to look at broad-based indices holding international equities if we are to achieve a more realistic picture of how a diversified equities portfolio might be performing and whether it too is breaking out above last year's highs.

For those investors wanting to look at broad indices with large international exposure, the MSCI EAFE Index, often traded through the popular exchange-traded fund EFA, is significantly below its May 2, 2011 high. The EFA touched $64.35 on that day and is currently trading at $54.52, a massive 15.28% below last year's high. This index represents so-called developed markets outside of North America. EAFE stands for Europe, Australasia and the Far East. As of February 16, 2012, EFA had 929 holdings, including ones from the United Kingdom, Japan, France, Germany, and Australia.

Another international index, the MSCI Emerging Markets Index, often traded through the popular exchange-traded fund EEM, is also well below its 2011 high. On May 2 of last year, EEM reached $50.43. Today, it stands at $43.93, a significant 12.89% below last year's high. The popular ETF representing this index has 840 holdings as of February 14, and includes exposure to China, Brazil, India, South Korea, and Taiwan.

If the Dow Jones Industrial Average is to be taken as a solid gauge for an equity market breakout and/or as a gauge of strength for the U.S. economy as a whole, many investors would expect to see some confirmation from small cap stocks, the transports, and semiconductor stocks. In fact, the Russell 2000 (NYSEARCA:IWM) is trading 4.59% below its 2011 high. The Dow Jones Transportation Average is 7.35% below its high of last year, and the Philadelphia Semiconductor Index is 8.94% below its February 18, 2011 high.

In the interest of fairness, the NASDAQ Composite Index has also broken out above last year's high. At the moment, the NASDAQ Composite is at 2,951.78, 2.22% above last year's high of 2,887.75. When trying to discover why such a broad-based index has been able to break out when other broad-based indices have not, we can look at the NASDAQ 100 (NASDAQ:QQQ), which represents 100 of the largest non-financial securities, based on market cap, listed on the NASDAQ Stock Market. The NASDAQ 100 has broken out far higher above its 2011 high than the NASDAQ Composite Index has (5.98% versus 2.22%). A large reason for this is due to the massive weighting and importance of Apple (NASDAQ:AAPL).

Apple, which has a 16.41% weighting in the NASDAQ 100, is trading 17.68% above last year's high. While Apple is not the only reason the NASDAQ is performing so strongly, it has a major influence in determining both the direction and magnitude of moves in the index. I don't want to dismiss the importance of the NASDAQ Composite Index joining the Dow Jones Industrial Average in breaking out above their 2011 highs. However, I do want to highlight that when investors dig down into the holdings of the NASDAQ Composite in order to determine the breadth of the breakout among individual holdings and compare this to the total number of publicly traded companies across various market indices, they might not be as impressed as they imagined they would be.

In closing, don't be fooled by an index that represents just 30 stocks. For now, things are going well in the equity market, but not as well as the Dow would imply. When trying to determine the importance of a breakout in the Dow Jones Industrial Average or the NASDAQ Composite as it pertains to equities as a whole, don't forget to look at other broad-based indices as well.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.