The Nasdaq Delusion

Most people spend their time thinking about exactly the wrong things, and with the Nasdaq down over 50% from its high, it comes as no surprise that there are plenty of opinions on what the next move might be. Should my retirement account rest in equities and nothing but equities because Abby Joseph Cohen makes a market call? Should I be bullish just because the perpetually tan Joe Battipaglia is bullish and can lay down a line of corresponding patter in a two-minute segment on CNBC's "Squawk Box"?

The debates are interesting — but ultimately irrelevant. As always, nobody knows the future. For every reason this might be a bottom, there are just as many signs that suggest the worst is yet to come. To that end, let us remember that there are no "right" answers, only answers that are right for your portfolio. What matters most is not your analysis of the stock, but your understanding of how the stock fits, or could potentially fit, into your overall position in the marketplace. Trading is an act of self-preservation. The real question isn't "What's next for the Nasdaq?" but how adding or subtracting a position in the Nasdaq might affect your overall risk exposure.

To answer that question, it helps to understand what the Nasdaq actually is and isn't — and how misconceptions about it have distorted people's view of what's really going on in the market. What we refer to as "the Nasdaq" is actually the Nasdaq Composite Index, which tracks all the domestic and non-U.S.-based stocks listed on the Nasdaq Stock Market — more than 5,000 in all.

That leads many to believe that the Composite is a good reflection of the overall market. But as broad as it sounds, remember that the Composite is an index. That means it's weighted by market capitalization. The bigger the stock, the bigger impact a move in its price has on the index.

So, far from being a gauge of the market as a whole, the Nasdaq Composite is biased toward the relatively small contingent of large-cap technology stocks. And that's where it begins to cloud our understanding of what's really going on in the market. Toward the end of the bull run, investors didn't just have a fascination with the market, but with the dozen or so large-cap stocks that dominate indexes like the Nasdaq Composite and the Standard & Poor's 500. And while both 1998 and 1999 brought dramatic gains in those indexes, they came on rapidly diminishing breadth. Indeed, most stocks went down in 1999.

As money poured into the market, most of it was directed toward this small number of highly liquid names, such as Microsoft (MSFT), Dell Computer (DELL), Intel (INTC), Cisco Systems (CSCO), Oracle (ORCL) and Sun Microsystems (SUNW). Large caps developed what came to be known as a "liquidity premium." Sure, they traded at unsustainable long-term multiples, but that was where the action was. You either owned the big dogs or risked being left in the dust.

This phenomenon also helps explain the craze for index funds. While supporters trumpeted their low cost and light turnover, what ultimately benefited index funds for most in the 1990s was that they focus by definition on large-cap stocks. The reason active managers weren't able to beat the indexes wasn't necessarily because of a lack of stock-picking prowess, but because they typically assembled diversified portfolios rather than just the big names of the Nasdaq 100.

And while many investors are confident indexing the big caps is still a can’t-lose strategy, diversification is back in style for the first time in years. Small caps, fixed-income securities and real-estate investment trusts have remained strong in the face of a melting Nasdaq 100. Sure, tech is breaking down — but the Value Line Arithmetic Index is breaking out. (The Value Line is an index of 1,700 companies from all three major exchanges. Unlike the Nasdaq Composite, which is primarily influenced by the big-cap names, the Value Line is equally weighted, so even the smaller stocks have an impact on its performance.) In short, it’s generally a good time to be a stock picker, not a bottom-fisher.

And now back to the question with which we began: What's the role of the Nasdaq in your portfolio? If you avoided the tech wreck and have no Nasdaq exposure whatsoever, this might be a great time to take a small initial position. You will move from having no tech exposure to having some — a prudent countertrend play considering the index is down so sharply from its all-time highs.

But if you are long and wrong in the Nasdaq 100, I think you've got to be insane not to use some near-term strength to at least reduce your exposure to big-cap tech. You'll still benefit if the market does eventually retest the highs — and you'll protect yourself in case the worst is yet to come.

Unfortunately, many people are still holding the big-cap names of the Nasdaq. They got long sometime around January 2000, when tech funds saw their biggest net inflows in history. While some money has moved out of the sector, there hasn't been a mass exodus by the average retail investor — even in the face of dramatic outperformance by other types of stocks.

Before we can embrace the future, we must put aside the past. And given the still excessive tech weighting in most portfolios, the QQQ (that's the tracking stock for the Nasdaq 100) is probably not the screaming buy it seems at first glance. Even if we do rally sharply from current levels, is it worth taking that risk — especially when there are so many other, more compelling places to park one's assets?

In the final analysis, asking "Is this a low?" is asking the wrong question. What really matters is whether you are in a position to ride out the answer.

Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management (Capitalistpig.com), a Chicago-based hedge fund. At the time of writing, Hoenig's fund was short shares of Cisco Systems.