The Benchmarks Lie. Here's How.

The benchmarks lie. Many investors, new and experienced alike, are intent upon "beating the Dow" or "beating the S&P," rather than seeing their capital increase over time. It isn't that difficult to beat the benchmarks. We've done it over 15 years from 1999-2014, and this year, the markets, so far, are down 6% to our 1%, so we ​hope to keep that trend alive.

On the other hand, for investors ​who place their faith in buying only companies that are in the benchmarks often find ​it is difficult to beat the indexes. That's because "the benchmarks lie." Every time a company disappoints the keeper of these benchmarks, the S&P Dow Jones Indices (a McGraw-Hill Financial subsidiary), they boot it out of the index and replace it with something they consider more "representative."

I don't believe it is a coincidence, however, that "representative" usually equates to rising relative momentum, making the index performance look considerably more attractive - although that index may have a completely different composition than the one you bought before all their changes. As for the companies booted out, they are still in business, but if you bought a mirrored portfolio of those 30 stocks, you own the same 30, though the index and its ETF​ clones own a very different index - and not because the​ component companies went out of business or failed to meet regulatory requirements.

Assuming the S&P Dow Jones Indices are correct in their momentum assessment, the results are regularly skewed upward. So, if you obsess over "why didn't the 30 Dow stocks in my portfolio keep up with the Dow Jones Index?" well, in November 1999, did you toss Chevron (NYSE:CVX), Goodyear (Nasdaq:GT), Sears (Nasdaq:SHLD), and Union Carbide out of your portfolio and replace them with Home Depot (NYSE:HD), Intel (Nasdaq:INTC), Microsoft (Nasdaq:MSFT), and SBC Communications (which, a few years later, acquired/became AT&T)? The S&P Dow Jones Indices​ did.​

In April 2004, did you sell AT&T (NYSE:T) (after just 5 years in the index), Eastman Kodak (out of bankruptcy ​now, ​and again trading on the NYSE, KODK), and International Paper (NYSE:IP), and instead, buy AIG Inc. (NYSE:AIG), Pfizer (NYSE:PFE), and Verizon (NYSE:VZ)?

Or, in September 2008, did you sell Altria Group (NYSE:MO) and Honeywell (NYSE:HON) in order to buy Bank of America (NYSE:BAC) and Chevron (which, I suppose the indices gurus decided was worthy once again)? In 2009, when Citigroup (NYSE:C) and General Motors (NYSE:GM) stocks were plunging, did you switch to Cisco (Nasdaq:CSCO) and Travelers (NYSE:TRV)? Or did you exchange AT&T for Apple (Nasdaq:AAPL) this year?

There are many other examples, but you get the idea. "Representative" seems to mean "on its way up" - though it doesn't always work out that way. A recent anomaly in the last couple of years indicates that some boot-ees do better than the new inductees, though it remains to be seen if this will continue.

That brings us to an interesting example ​just today ​​of how trying to read too much into a benchmark can confuse or backfire. The S&P closed down 0.35% and the Nasdaq closed down 0.7% - but the Dow is up .08%. How come? Well, the Dow has only 30 components, so if one of them soars or plunges on one day, it can affect the index out of proportion to its long-term trend. Today, it was DuPont (NYSE:DD) that sent the Dow ahead (which will no doubt lead some feckless commentator to claim that since the Dow means Blue Chips, the "leadership of the Dow today proves" that the markets will rise.) But what was the reason ​the Dow rose as ​DuPont rose 10% today? The CEO said she would retire, giving rise to speculation that the company may be broken up - hardly an event likely to be repeated every day.

The bottom line is that I continue to believe that intelligent stock (and preferred, bond, ETF, CEF, and mutual fund) selection remains key to market success, that indexes can be beaten by this approach, and that markets go up and down - meaning there are times to enter trailing stops and adjust your portfolio percentages to include more cash, bonds, or hedges. In my next article, I will give some ​current ​examples.