Managing Portfolios For Today's Opportunities and Tomorrow's Challenges

You've seen the headlines. You've seen it on TV. You've probably read it on the Internet. Alas, it must be true. Since the bear market reversed course in October of 2002, the market gains have been led by the NASDAQ index. Interestingly enough, that's not necessarily the truth. Only if you measure the nadir of the bear market plunge as a starting point does the NASDAQ outperform the Dow and the S&P 500. On a weekly close basis, the NASDAQ hit bottom at 1,139, the S&P 500 hit bottom at 800, and the Dow at 7,528. Therefore it takes fewer points to magnify the percentage change on the NASDAQ as opposed to the Dow. But is 'the bottom' a realistic way to measure returns?

Think of your portfolio as being inside a vessel at sea. The last thing you want to happen of course is for the vessel to sink below the surface and put your portfolio under water. Your goal is for the vessel to catch the waves and propel your portfolio to exciting heights like a pro surfer. You want to 'hang ten'. You want to 'ride the tube'. You want to… well, you just don't want your portfolio to sink. But what if it does? What if your portfolio is inside a vessel riding the surface at 11,722 feet above the bottom? If your vessel sank some 4,194 feet below the surface, how would you measure your performance as your vessel then righted its descent and began to climb? Would you be satisfied if your vessel rose 1,000 feet? Certainly you could get excited at a 2,000 foot rise? A 3,000 foot rise would be cause for celebration and you might be willing to take your portfolio out of the vessel so you could give it a hug. Unfortunately, though, it would drown if you did because it would still be below the surface. This is the case of the Dow Jones Industrial Average. As of this writing, the Dow has plunged some 4,194 points from its high of 11,722 only to retrace some 2,570 points. That still leaves us some 1,624 points below the surface. Can we now take a deep breath and raise the victory flag?

While it is nice for the stock market to go up in 2003, it is important to keep the benchmark indices in perspective. It is also helpful to focus on reality. If you measure from high to low and then the percentage of retrenchment, you get a different perspective on 'out performance' and 'underperformance'. The accompanying chart shows the real story. Before any index can take a breath of air and declare victory for investors, it has to get back to the surface. Which index is really the closest?

By continuing with our example of a vessel that is under water with our portfolio inside, let's see which index is really outperforming. It becomes rather obvious that the Dow is the clear winner so far. That's right, I said 'the Dow'! It has retraced 62% of its 4,194 point drop. The S&P 500 trails significantly with only a 38% retrenchment of its 727 point drop and the NASDAQ is a woeful underperformer with only a 21% retrenchment of its 3,909 point drop. Now which index would you rather invest your portfolio? You may even feel duped by the media at this point and want to rush out and buy every Dow stock that you can get your hands on.

But wait! This piece should serve as a double warning. First, if we are really in a 'bull' market, wouldn't you expect the tech-heavy NASDAQ and Russell 2,000 to seriously outperform the Dow? Normally that's the case. Second, have you ever heard of the 'golden ratio'? This is the Fibonacci ratios that Elliot Wave technical theorists use for things like bear market retrenchments. It just so happens that retrenchments have a bad habit of meeting 38%, 50%, and 62% levels and then having these points become resistance levels. The chart may be a bit spooky but take a close look. The Dow and the S&P 500 are now sitting on 'golden ratio' retrenchment numbers. The good news is the NASDAQ may have some room to grow but be careful. Now is not the time to get too crazy and overextend your self financially. These retrenchment levels are like seeing the shadow on the bathroom wall in the movie Psycho. You have been warned!