June 24, 2006

In This Issue:

Investment Idea
Quiz
Our Results
Market Highlights
Behavioral Finance Indicators
Answer to the Quiz

Investment Idea

Question: There are three ways of constructing an index. Which type of index offers the best potential for individual investor ?

Answer: Let us first define the three ways of constructing an index:

1. Price-Weighted Index e.g. Dow Jones Industrial Average

Stock A = $2. Accounts for 20% of the index

Stock B = $8. Accounts for 80% of the index

2. Equally-Weighted Index e.g. many ETFs

Stock A = $2. Accounts for 50% of the index

Stock B = $8. Accounts for 50% of the index

3. Capitalization-Weighted Index e.g. S&P 500

Stock A = $2; shares outstanding = 50; market capitalization = 2 * 50 = 100.

Stock B = $8, shares outstanding = 5; market capitalization = 8 * 5 = 40.

Therefore,

Stock A accounts for 100 / 140 = 71% of the index

Stock B accounts for 40 / 140 = 29% of the index

What does it mean to you?

In a long-run, small capitalization stock indexes tend to outperform the general market. Therefore investors should hold more Equally-Weighted Indexes as they give a greater weight to small caps. At the same time, buying a broadly diversified index protects from the risk of holding an individual company.

Quiz

What is the market capitalization of the company XYZ with 200 shares outstanding trading at $10 per share ?

A) 2,000
B) 20,000
C) 1,000
D) 10,000

Answer to the Quiz at the bottom of the newsletter

Our Results (Cumulative %)

Chart 1.

Last week, InvestWELL Picks managed a small gain while the general market declined.

Market Highlights

June 18 - Jun 24, 2006

• Last week, the US equities attempted to stage a rally but finished the week only with a modest decline (Chart 2 & 3). It does appear, however, that the market has managed to build a relatively strong support which will be crucial for a successful development of any rally.

Charts 2 & 3. S&P 500: 5 Years and Last 10 Days

Charts courtesy of StockCharts.com

• Last week, the Canadian equities posted solid gains as investors renewed their faith in the Canadian markets (Chart 4 & 5). In addition, a number of recent economic reports indicate that Canada will likely continue to benefit from strong macroeconomic fundamentals.

Charts 4 & 5. TSX Canada: 5 Years and Last 10 Days

Charts courtesy of StockCharts.com

• The US crude oil inventories reached their eight-year high, while the price per barrel is about $70. Eight years ago, the price per barrel was $16. Times have definitely changed.

• Mortgage rates in the US have hit their highest level in four years. At the same time, the home builders’ confidence index fell to an 11 year low. Many analysts are justly concerned about the potential ripple effect of the decline in the housing market on economic growth.
  
• Chief executives of U.S. corporations earned 262 times the pay of the average worker in 2005. We will not comment on this market misallocation.

Worth Watching

• The phenomenal growth of hedge funds during the last 15 years has come at a cost. The funds, which aim to exploit market inefficiencies, have been criticized for their secrecy and practices as well as their impact on the markets. The regulators (e.g. SEC) have made efforts to understand and influence the industry. Let us face it; the hedge fund industry needs some form of regulation to protect investors as well as the equity markets (do we need to mention the potential impact of Long-Term Capital Management following the Russian crises in 1998?)
  
• Please note that the recent correction is merely a return to the lower end of the channel that has been established since summer 2003 (Chart 6). Now, having tested the recent lows, we have a high probability that equities will attempt to rally back to the higher end of the channel.

Chart 6. S&P 500 Trading Channel: 3 Years

Chart courtesy of StockCharts.com

Behavioral Finance Indicators (see explanation)

According to our behavioral indicators, the equity market is ready for a short-term rebound which will likely happen at the end of June / start of July. In addition, the contrary indicators have been flushing strong oversold signals as the market consolidated at the lower end of the trading channel. However, in a longer-term time frame, the market will find it very difficult to climb back to the levels reached in last May.

Please consider the following factors:

• Chart 7 –the prices (black line) and the advancing/declining line (red line) are converging but the two started to diverge in February this year which signaled that the market was heading for trouble.
  
• Chart 8 –a low confidence of small investors (as represented by AAII, i.e., the ratio of bulls/bears). Small investors are usually a contrary indicator.
  
• Chart 9 –the rising put/call equity ratio indicates that small investors are losing their confidence that the market will advance (red line). Again, an excellent contrary indicator.
  
  Charts 7 - 9: Advancing/Declining Line, AAII and Equity Put/Call Ratio
  
    
  
  Charts courtesy of StockCharts.com and DecisionPoint.com

Answer to the Quiz

A is correct. We need to multiply the number of shares outstanding by the current price i.e. 200 * $10 = 2,000.

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InvestWELL Financial’s first priority, as a provider of independent and unbiased financial information, is to educate our clients. Not only do we provide practical information about securities, but we also coach our clients to become successful independent investors. As such, InvestWELL Financial does not assume any responsibility whatsoever for the use of any information from the website or related publications. Although all sources of information are vetted and the information is believed to be reliable, it is not provided as investment advice. Past performance is not an indicator of future performance in securities. Each portfolio must be balanced and based on personal circumstances. High-risk investment decisions should be made in consultation with an investment professional.

InvestWELL receives no commission or benefit of any kind from the companies whose securities InvestWELL Financial showcases. We do not necessarily own shares in the showcased securities, but if we do, these shares would only form a very small part of widely-held and publicly distributed companies. There is no intention whatsoever of profiting in a manner where the price-impact of trading or holding of a security might arise. The website and related publications of InvestWELL Financial are intended to only be used for educational purposes.