By Andy Obermueller
The market is on the move. An April 2 article in The Wall Street Journal noted that "the eurozone has stepped back from the brink of collapse, the U.S. economy is showing continued signs of life, and central banks have extended efforts to support economic growth."
The piece, by Tom Lauricella, continues with the idea that the stock market is no longer moving in lockstep with other asset classes, which some take as a sign that it is about to break out. "Cautious investors have scaled back holdings of high-quality low-yielding government debt that had been a haven from last year's turmoil" and are "willing to take greater risks."
Well, no surprise there -- the market has been rising this year without a material change in the underlying fundamentals. In fact, as the article notes, earnings this year are likely to be weaker than in 2011. This leaves shifting investor sentiment about the market's future prospects as the only reasonable explanation for the upswing. The point of the article is that more and more risk-averse investors are beginning to look for better returns than cash or fixed income can provide. Their collective higher risk tolerance means they are willing to crawl out from under their rocks and embrace equities.
As a great investment sage once said, "So what?"
I mean, to what degree can these investors continue to find the same standout gains seen in the first quarter in the same places investors usually look? In other words, what is the built-in high for the blue chips these investors are buying?
On an economics front, of course, the sky is the limit, because stock prices can theoretically rise forever. In the real world, though, stocks meet resistance at a certain point and it's not too onerous to determine where that is. In fact, it's just basic arithmetic.
The Dow Jones Industrial Average, as you know, is made up of 30 mega-cap stocks, the bluest of the blue chips. To determine the value of the index, the individual share prices of each of the members of the Dow are added together. The sum is then divided by the "Dow divisor," a special mathematical tool that allows the editors of The Wall Street Journal -- who pick the index constituents -- to make substitutions in the Average. They do this rarely, but without the divisor, they would not be able to do it at all, unless the new stock had exactly the same price as the old one.
The current divisor is 0.132129493. (And if you really want to impress your friends, lay this fact on them: A $1.00 rise in the total price of the 30 stocks results in a 7.6-point gain in the Dow.)
So to determine the market's built-in high, I used the 52-week high for each stock instead of its current price. The built-in high is almost exactly 14,000, or only about 7% above the Dow's current reading. The members of the Dow have to make up all the ground they have lost in the past year and then break new ground to push the index above this point.
If you're a reader of my newsletter, then you should remember Obermueller's Law: The market is always trying to tell you something.
In this case, the message couldn't be clearer: No one seeking an equity return in an otherwise up-trending market chases a 7% return very hard. When the blue chips reach their highs -- and 18 of the 30 are already within 4% of that, with seven of them within 1.0% -- the asset class exhausts its appeal for aggressive growth investors.
It follows, then, that the next step is for more risk-tolerant investors is to look to something other than blue chips, something with a little more zing to deliver disproportionate returns -- "alpha" in market lingo.
This is exactly the sort of thing you need to consider, too.
As blue chips begin to break new ground -- which ultimately is a matter of "when" and not "if" -- I think it will lead to a massive shift in interest to small- and mid-cap stocks. As large caps crest, most investors -- captive to the self-defeating idea to buy when everyone else is buying -- will move sidelined cash into blue chips and reallocate fixed-income assets into indexed equities.
While these investors are coming in the front door, buying stocks, another crowd will be leaving out the back door, selling. The savvy investors who rode the blue chips from the market's bottom to the summit will likely move on to greener pastures, following the adage that (smart) money goes where it is treated best.
In this case, it's small- and mid-size stocks that will treat your money the best in this market. And if you allocate a small portion of your portfolio, say 20%, to small companies that are working on "the next big thing," then you're very likely to find yourself sitting on big returns -- even when the overall market has hit its ceiling.