Traveling.

Traveling this week, so posting will be erratic.

Quick thoughts: Shorting this market must be hurting! Looks like we're headed towards 980-1020 on the S&P 500. The trend is surely up..

Turns out DOW opted for a non dividend paying name like Cisco(they never had an explicit policy which stated so), though the obvious price-weighted disqualifiers like Google(GOOG), Apple(AAPL) and Goldman Sachs(GS) were indeed not considered. Actually, thinking further on this, Microsoft(MSFT)wasn't paying a dividend yet when it was inducted. So there's some precedent. I'll keep an eye on Cisco for starting that dividend stream sometime in the next 2-3 years.

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Google in Dow: are you kidding me? A look at possible replacements.

It’s almost a foregone conclusion that General Motors (GM) is going to be replaced from the Dow. People have started speculating on possible replacements:

From Yahoo Finance:

In a research note last month, Nicholas Colas, chief market strategist for BNY ConvergEx Group, laid out seven possible replacements for GM: bankers Goldman Sachs Group Inc.(GS) and Wells Fargo & Co.(WFC); high-tech firms Cisco Systems Inc.(CSCO), Apple Inc.(AAPL), Google Inc.(GOOG) and Oracle Corp.(ORCL); and agricultural products maker Monsanto Co.(MON).

Based on the market moving impact of high price stocks on the Dow index, I would safely rule out Google, and even Goldman Sachs and Apple would be pushing the envelope. Why? If Google were to be added at the current price, it would comprise 28% of the Dow index! Thus Google CANNOT possibly be a serious candidate for the price weighted Dow. With close to 10%, the biggest weight in the Dow currently is IBM. Even Apple or Goldman Sachs would contribute close to 11% and 12% respectively to the index, which is why I think their addition to the index is unlikely.

If that’s not reason enough, here’s another fact: What's the number of current Dow components not paying a dividend? Answer: ZERO. If this were to hold true going forward, that would rule out Google, Apple and even Cisco from the list of contenders. (Now, I know Cisco CEO John Chambers has promised a dividend before he quits, but that’s not happened yet.)

So assuming the analyst got the initial list of candidates right, there are only three possibilities in my opinion: Oracle, Monsanto and Wells Fargo.

I did some further reading and pulled together a list of additional replacement candidates from various commentators:

• WSJ’s Marketbeat suggests Deere (DE), Toyota Motor(TM), and British Petroleum (BP).
• Felix Salmon adds Amgen(AMGN) and Nike (NKE) to the list.
• CNN Money suggests Pepsi(PEP), Conoco Philips(COP) and Schlumberger(SLB) as additional names.


• Fox Business quoting Wall Street analyst Matthew Hougan adds Philip Morris (PM).
• This Reuters article further suggests Aetna(AET), FORD (F), Nucor(NUE) and Travelers(TRV).
• This CNBC article suggests, in addition to the names listed above, Amazon (AMZN) and Abbott Labs(ABT)

After the removal of Honeywell(HON) and Altria(MO) from the Dow, here’s what the committee had said:

On CVX addition: "As usual when we make any change we review all the stocks. In doing so, we saw that the financials industry was under-represented -- notwithstanding the current turbulence -- and that the oil and gas industry's growing importance to the world economy called for another representative to join ExxonMobil Corp.

On Honeywell removal: “Honeywell is being removed because it's the smallest of the industrials in terms of revenue and earnings. Additionally, the role of industrial companies relative to the overall stock market has been shrinking in recent years.”

At that time, Honeywell had net income of approx. $2.5 Billion, and revenues of ~ $35 Billion.

With Oil down to less than half from the peak, it seems unlikely that the committee would add another oil major, which makes me want to rule out COP, SLB and BP. Further, because of their emphasis on revenues and earnings, I would rule out Amgen, Abbott Labs, Nike, Nucor, Amazon and Aetna.

After adding AIG and BAC in the last 10 years and watching them lose most of their stock value, I’m not too sure how enthusiastic the board will be about adding another financial to the list, except perhaps to replace an outgoing financial.

This would leave: Oracle, Pepsi, Deere, Monsanto, Wells Fargo and Philip Morris as the serious candidates. PM and PEP sound like safe bets in this uncertain environment. Monsanto would be an interesting name given that agriculture could be a big growth industry going forward. One interesting pair which hasn’t been discussed are the drugstore chains, CVS and Walgreens. The Dow is underweight financials and health care compared to the S&P 500, so we could always see a name from those sectors.

If I were to make a guess, CVS/Walgreens, Oracle, Pepsi, Monsanto, Wells Fargo and Philip Morris would be my replacement picks. While I might be wrong on some of my conjectures, what seems certain is that the new Dow entrant is definitely not going to be Google.

Time will tell. Stay tuned!

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A detailed look at Dow: did GM bring it down today?

The headlines were screaming: Dow closes in the red today after GM's late-day skid. Perhaps a more appropriate headline should have read: A 25% decline in GM barely budges DOW. (After all, Dow was only down 0.18% today). The massive 25% decline in GM stock contributed only about 0.04% to Dow’s decline! (or about 25% of the day’s decline). So much for the adage, "as GM goes, so goes America".


The Dow is a price weighted index, so as the price of a stock goes to zero, the impact on the index becomes increasingly insignificant. The upshot is that GM’s contribution to Dow is basically non existent. If GM were to file for bankruptcy, and GM stock goes to 0, (or $0.01 as detailed in this SEC filing), the Dow would only be down by 0.1% because of it. That’s noise basically.

Just for fun, I decided to calculate the Dow Jones index with various components removed:




As can be seen, the impact of removing General Motors(GM) and Citigroup(C) from the Dow is only 0.5%. Looks like Mr. Market has basically priced in a GM bankruptcy and Citi common equity getting diluted to oblivion. Further, Bank of America(BAC) or General Electric(GE) going to zero would only result in declines of 1.06% and 1.26% respectively. Even including all four, we're looking at a 2.8% decline. So basically all these components becoming pretty much worthless is already priced in. What's NOT priced in however, is these components going back to their earlier price highs.

Wintel's effect on Dow: Just for fun, and for the sake of illustrating the weirdness caused by using price weighted indexes, I've included the impact on the Dow of removing Intel(INTC) and Microsoft(MSFT). As can be seen from the chart, both Intel and Microsoft can go out of business, and the Dow would only suffer a 3.3% decline.

Role of financials in Dow: Let’s assume that things become great and the financials go back to their pre-crash market capitalization. Even then, because of the record high equity dilution in the financials (because of TARP injections, preferred to common conversion, raising capital in the form of equity, etc) their stock prices would remain low (unless they do a reverse split). Because Dow is price weighted, what that basically implies is that the financials would have an increasingly small role to play in Dow’s daily gyrations, even assuming they go back to their previous market capitalization highs.

Financials under performing in the next bull market is almost a certainty as far as the Dow is concerned.

The data above basically shows how concentrated the Dow index really is. For all practical purposes, Dow is a 26-27 component index today.

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On the strength of the transports, and commodity weakness..

From the video interview of Barry Ritholtz, came across this interesting comment:

Coal is a huge story. Strength of the transports does not mean economy is getting better. Thanks to a weaker dollar, we are exporting a lot more fertilizer and coal. North America is the Saudi Arabia of coal. (Likes ACI)

The basic point is that the transports reflect the underlying strength of the agricultural(commodities) and the energy sector, which the industrials don't. Dow theory as practised in the past may not be a relevant barometer of domestic stock market strength in a globalized world. Though this is an interesting point, I'm not completely convinced, yet! The Dow industrials are composed of companies who predominantly sell outside the US, alongwith commodity names like Caterpillar. Are the higher commodity(fertilizers) and energy(coal) demand a result of a weaker dollar, or the secular demand from the engines of India and China? I would argue for the latter.

The commodities and energy sectors are going through a speculative blow-off. They are cyclical sectors disguised in a 'secular term' trend. While I don't dispute the 'secular' uptick in demand due to consumption in the emerging markets, to expect the commodities sector to be impervious to a global slowdown is baloney.

Here's the punchline and a prediction (for what it's worth!): The current correction in the commodities space is not a multi-week phenomena. I'd argue that this time next year the commodities sector will be lower than where it is today. Given the cyclicality of the commodities sector, I would expect the transports to roll over and join the industrials.

The positive divergence we have seen in the transports is at best a short to an intermediate term bullish signal. The Dow theory sell signal of 2007 is still very much valid, and the rollover in the commodities space is only a confirmation of that.

Secondary point: While I'm positive on coal, I'm even more positive on natural gas and LNG(and would prefer holding CHK to ACI) . Carbon trading and emissions control(whenever that happens in the next 5-10 years) will make these more profitable and desirable energy sources, when compared to coal. (But maybe they'll come up with a way to make 'clean coal', and this point would then be no longer valid. )

Ah! The joys of investing and identifying secular term trends!

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Indicator review time!

Three indicators which confirmed the intermediate term bottom.

1. The DOW transport didn't confirm the downside to the DOW industrials. It held it's Jan lows. This strength has to be respected.






2. The VIX was 20% above it's 10 day SMA, indicating an oversold market due for a bounce.

3. Philly SOX starting outperforming S&P 500, indicating a selling washout.

There are other well documentated indicators, like advisor equity exposure recommendtion, CBOE put/call ratio which were also at multi-year low levels.

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