How to Spot Trouble Signs as the Index Turns

05/19/2017 2:59 am EST

Focus: STRATEGIES

Jackie Ann Patterson

Author, Truth About ETF Rotation

Index investing in ETFs doesn’t mean your portfolio can’t take a gut-shot dive, asserts Jackie Ann Patterson. Signs an index may be getting into trouble include narrowing breadth. She has more than 20 years of experience in the markets and has written several books.

World news and market commentary tend to dramatize current events. Why? Because as humans we’re attracted to stories, and a dramatic arc is the heart of story.

However, managing your investments with too much attention to the storyline–whether it’s the exhilarating heights, wretched lows, or ain’t-it-awful narrative – can result in buying into the highs and selling into the lows, which is a sure way to eat up your nest egg.

Investing in an Exchange Traded Fund (ETF) built on a stock index has become accepted as a way to drama-proof investing.

Index investing doesn’t mean your portfolio can’t take a gut-shot dive though. That’s the real test of confidence in passive investing, and sadly many individual’s emotions lead them to sell near the bottom.

It doesn’t have to be this way. We can watch our indices for signs of trouble and move to our funds to safety.

The key question is when. If we move out at every little dip, we run up transaction costs plus taxes, and often have to buy back higher. But we don’t want to wait so long that it feels like riding a plummeting comet.

Signs an index may be getting into trouble include narrowing breadth. There is a saying that a rising tide lifts all boats, and it is often the case that a strong rise early in a rally will enjoy broad support. As time passes, market favorites emerge which lead the way. For example, enough individuals and institutions have invested in Apple (AAPL) to grow its market capitalization to $800 billion. It is the largest holding of both the SPDR S&P 500 ETF Trust (SPY), and PowerShares QQQ Trust (QQQ) at 2% of total assets and 11% of total assets respectively.

The top ten holdings of SPY account for 18% of its assets. That means 2% of the companies in the S&P 500 control almost 20% of its value. For the QQQ, the situation is even more extreme. The top ten holdings account for 51% of the total assets of this popular NASDAQ index. That means 10% of companies in QQQ control over half of its value!

These larger companies are often perceived as safer and more popular. As a bull market gets extended, and worrisome events occur, investors and particularly fund managers may seek the peace of mind of companies that have proven their strength by captivating the market.

As money moves out of the smaller, lesser known companies, the indices may continue to look stable due to the influence of the top holdings. However, this narrow breadth can be a sign that confidence in the market is much lower than would appear from the price of the index.

Decrease in breadth is one of the early danger signs. It does not necessarily imply an immediate decline in the value of indices. Tough investors may choose to wait until immediate price-driven sell signals appear. These may include a gap down on large volume, a break of significant support, a Death Cross of the 50-day MA going down through the 200-day MA, or a break of the uptrend line.

Watchfully waiting for signs that the index is actually turning over can help individuals stay with the normal fluctuations of the market while being ready to exit before an overly painful decline.

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