THE ADVENT OF

exchange-traded funds is challenging long-held beliefs about how stock markets work. At least that's what options guru Bernie Schaeffer contends. The chief executive of Schaeffer's Investor Research says ETFs have led to a commoditization of the stock market as more investors seek exposure to the entire Dow Jones Industrial Average or Standard & Poor's 500 index rather than the individual components. He might be on to something. The

SPDRs Trust

While investors can gain similar exposure through index mutual funds, Schaeffer thinks ETFs are especially influential because of their growing popularity and the ability to trade options on them. In addition to Spiders, as the SPDR Trust is commonly known, the Diamonds Trust tracks the Dow and the Fidelity Nasdaq Composite Index Tracking Stock follows more than 3,000 Nasdaq-listed stocks.

Schaeffer cites the Dow's recent run-up as evidence of the evolving influence of ETFs on major stock-market barometers. In the past, index highs were usually accompanied by highs for many individual stocks. If they weren't, then it signaled a weak bull market and an impending correction. Yet, when the Dow peaked recently none of the components set a 52-week high. That, says Schaeffer, indicates strong demand for Diamonds, which lifts all 30 of the industrials rather than just the strongest stocks among them, and not the start of a marketwide downturn.

Paul Desmond, president of Lowry's Reports, the oldest technical-analysis firm in the U.S., isn't sold on Schaeffer's theory. Unlike fundamental analysts, who study balance sheets and income statements, technical analysts follow charts and look for trends. Technicians believe a lot of stocks need to make new highs for a healthy rally, while few new highs indicate a weak one.

Earlier this year Desmond wrote a report disputing the assumption that most stocks on the New York Stock Exchange reach their highest prices in unison with the Dow. He found that in each of the 14 major bull markets from 1929 to 2000, on the day the Dow topped out, an average of 22% of all NYSE stocks were already 20% off their highs. "The absolute top for the vast majority of stocks had probably occurred months, perhaps many months, before," said the report. In each bull market, fewer than 11% of the Big Board's stocks made new highs along with the Dow's peak, and the average was just 6%.

"When the Dow Jones Industrial Average made its new six-year high on April 27," says Desmond, "the percentage of NYSE stocks making new highs was 6.27%. When the Dow rose to a higher high in early May, that percentage rose to just 7.57%."

According to Schaeffer, in the past individual stocks drove the market higher in a bottom-up fashion. But indexing via ETFs is a top-down approach because it purchases each member of the index. This more egalitarian way of investing gives laggards an equal share, creating a rising tide that lifts all stocks. This can in turn boost indexes to new highs, as it did for the Dow, without pumping up individual components too much.

"The conclusion would be to not get too bearish based on the fact that only 7% or 8% of NYSE stocks are making new highs," says Schaeffer. "In the past that would be a red flag, that the underlying health of the market is suspect because we're not getting adequate participation. However, I would not rush to conclude that the market's health is not what it should be given these low rates of new highs."

Schaeffer acknowledges Desmond is "impeccable" at historical figures. Still, he thinks individual stocks are less important as fast-money hedge funds, a huge factor in market movements since 2000, focus more on ETFs, stock index futures and index options. Schaeffer says the beauty of ETFs is the ability to take positions on the broad market or a particular sector. And if ETFs rather than stocks are driving the market to new highs, it shouldn't be surprising that the Dow can post a six-year high without component stocks doing the same.

"Desmond's indicator has been diluted. It doesn't mean what it used to mean," says Schaeffer. "In an ETF world, this indicator's significance is suspect and doesn't cause me to be concerned about the health of the market."

Desmond isn't throwing in the towel.

"Bernie may be right about the Dow, but I don't think the same logic can be applied to the NYSE or the Nasdaq," says Desmond. "We are seeing a change in investor psychology. Many technology indexes topped out in January and have been in a down-trend since."

Schaeffer says ETF options are also having a mitigating effect on broad stock declines by adding structural support to the market. If an investor believes an index will fall, ETF puts provide the right to sell an entire index at a certain price by a specific date. While some investors may be speculating on a market decline, Schaeffer says most buyers of puts want to protect their portfolios, which actually helps the overall market.

"To the extent that a large constituency owns puts, they don't need to sell when the market pulls back because they have protected themselves," says Schaeffer. "That is supportive of the market. In the period after 2000, the market was very vulnerable to the panic pullbacks. But because they've insulated themselves from a panic selloff, heavy put activity insulates the market from panic selling."

J.D. Steinhilber, president of AgileInvesting.com, a Nashville investment advisory firm that manages ETF-based portfolios, questions that logic.

"I don't buy it. I don't think Schaeffer backs up his theory with any kind of data," he says. "Indexing is still a relatively small percentage of market activity, 15% at the most. I think it's exactly like the way he says it used to be. To me, it's obvious we are seeing the old behaviors of leading stocks. Look at the commodities and energy sectors. That is where the money has been flowing and that is creating the divergence and poor breadth."

The coming weeks and months will put Schaeffer's theory to the test. If he's right, then the current bull market shouldn't be in jeopardy. But if he's wrong and the old rules apply regardless of the explosion in ETFs, then the market could be teetering on the brink of a downturn.