outside-the-box-etfs-are-compounding-the-divergence-between-the-dow-and-the-nasdaq-100

Outside the Box: ETFs are compounding the divergence between the Dow and the Nasdaq-100

Finance

A divergence has recently taken place between the Dow Jones Industrial Average and the Nasdaq 100, and it was compounded by the popularity of market-based ETFs. Investors should be aware of, and prepare for, similar nuances related to ETFs in the future.

Boeing BA, -1.02% has dragged the Dow DJIA, +0.03%   down, while Apple AAPL, +1.11% has driven the Nasdaq 100 NDX, -0.19%   higher so far this week; this is relatively clear when looking at the headlines too, but the ETF influence is not as clear.

The Dow is comprised of only 30 stocks, and that makes it vulnerable to big declines when one stock, like Boeing, moves down so much so quickly. When this happens, investors shy away from ETFs that are tied directly to the Dow, and when they do that the buying interest in the other 29 stocks falls too.

Purchases of ETFs like the SPDR Dow Jones Industrial Average ETF Trust DIA, +0.07% and ProShares Ultra Dow30 DDM, +0.09% might be second-guessed because investors know the Dow is getting hit, when the only real culprit is the lone lame duck (in this case, Boeing); the other 29 stocks can suffer by simply being part of the index when situations like this happen, even though they shouldn’t.

This is where the opportunity comes from.

At the same time, Apple is the most influential stock in the Nasdaq-100, which is comprised of only 100 stocks. Therefore, big moves in Apple can have a strong influence on the Nasdaq-100, and that is what happened this week too. Unlike in the Dow, however, it was a positive influence.

The strength in Apple could have influenced additional purchases of ETFs like the Invesco QQQ Trust QQQ, -0.17%  and the ProShares Ultra QQQ QLD, -0.38% Because these ETFs essentially buy all the Nasdaq-100 stocks when the ETF is purchased, the other stocks in that market likely saw buying interest that would not have otherwise been there. This reveals opportunity too.

Neither of these markets is as broad as the S&P 500 SPX, -0.09%  or Russell 2000 RUT, -0.40% and it is this finite structure of the Dow and the Nasdaq-100 that allows this ETF nuance to exist. One stock can influence these markets, that’s pretty clear, but that influence compounds when it also influences decisions in the Market based ETFs too.

What to look out for

When a market like the Dow moves down aggressively due to news from one stock, and other stocks in the Dow seem to be getting hit simply because they are in the same market as that lame duck, consider a contrarian trade.

Look for stocks that are getting hit simply because they are in the same market, and look for a trade to develop and be fulfilled as the isolated news is absorbed by the market and those stocks that were hit bounce back into parity with where they should be, which is often the case.

Thomas H. Kee Jr. is a former Morgan Stanley broker and founder of Stock Traders Daily, where he is chief market strategist. He has no positions in any of the ETFs mentioned.