The “Internal” as Opposed to the “External” Stock Market

Financial news reports tend to focus on gains and losses recorded by a selective group of popularly followed stock market indices. These include the Dow Industrials, with 30 issues, unequally weighted (higher-priced issues have a larger influence, on the index); the Standard & Poor’s 500 Index, with 500 stocks (weighted by capitalization so that the index is unequally weighted, with larger companies more influential than smaller companies); the Nasdaq Composite Index, with approximately 3,500 separate issues (heavily weighted by capitalization so that at times perhaps only a dozen or so issues cany a very disproportionate effect); and the New York Stock Exchange Index, which includes all issues on the New York Stock Exchange (also weighted so that larger companies most heavily influence the average).
Another index, the Value Lie Arithmetic Average, includes approximately 2,000 issues traded on various exchanges and is not weighted by capitalization: All companies in that average are afforded equal weight.
Arguments can be made for or against the weighting inherent in most of these market indices, but the simple fact is that there are often serious discrepancies between the movements of one or more of the weighted indices and the movement of the typical listed stock. It is very possible for a weighted market index to advance in price as a result of strength in a handful of larger companies while the majority of stocks is actually declining. Popular market indices represent the “external stock market,” a view of the market most frequently observed. Indicators that measure the numbers or proportions of issues that actually participate in market advances and declines are measures of the internal strength or breadth of the stock market, a generally her reflection of the strength of the typical stock and mutual fund.
As a general rule, the stock market is on firmer ground when market advances are broad and include large percentages of listed issues than when they are selective, with advances in market indices created by strength in a relatively narrow group of highly capitalized issues. This is actually quite logical. If larger percentages of stocks are participating in market advances, the odds of selecting and holding profitable positions increase. If only a relatively small number of stocks are carrying market indices upward, the odds of successful stock selection narrow. Investors are more likely to fmd themselves taking losses in a stock market that seems to be rising if judgments are based on weighted indices, but that, in fact, is rising only selectively External readings are strong. Internal breadth measurements indicate otherwise.