Mike Lipper’s Monday Morning Musings
Understand
Numbers Before Using
Editors:
Frank Harrison 1997-2018, Hylton Phillips-Page 2018
The most common mistake made by investors is too brief an introduction
to the investment and economic numbers used by most who chatter about “the
Market” or the “Economy”. For example, the three most quoted US stock market
indices are the Dow Jones Industrial Average, the Standard & Poor’s 500,
and the NASDAQ Composite. Each of these unique indices was created for a
specific purpose and was designed for a specific audience. However, they are now
used for numerous purposes worldwide, including New York, Chicago, Washington,
London, Tokyo, and Shanghai. The biggest mistake is assuming the indices are identical.
Although the indices all have short comings, proper use of the numbers can lead
to useful insights in making decisions.
“The Dow”
The most well-known of all market indices is the “Dow” (DJIA), although it was
not the first indicator from the Dow Jones newsletter writers. They originally tracked
the performance of trunk line railroads as the most important stocks in the
18th Century. Later, due to the industrialization of America, they created an
index of a small number of large industrial company stocks. The main readers of
their newsletter were retail brokers. At that time, it was believed that the
higher the price of shares the higher the quality, making them more valuable.
This led the DJIA to be weighted by the prices of the shares. As is often the
case, there was unanticipated demand for the results achieved by the index. Consequently,
they took advantage of the wire systems of both the large “wire houses” and the
press in developing a national and international market for the index. (The
equivalent of the Rothschild’s carry pigeons.) Most local papers, and later
radio/television, quoted the close of the NYSE market by using the “Dow”.
Thus, across the US many more people than owned shares were exposed to
the index.
The Washington Applications
Political people in Washington started following the index as a measure of the
economy. They used it as a gauge of what local voters thought about the
economy. The Fed’s Open Market Committee consisted of a rotation of the
presidents of the local Federal Reserve Banks, whose districts were roughly
tied to the size of the financial assets the local reserve banks supervised.
The boards of directors of these local reserve banks all have financial leaders
familiar with the DJIA. Thus, the index became an unofficial factor in bank
regulation. Fed PhDs, recognizing the
limits of a 30-stock index in producing many economic studies, used NYSE data to
supplement the DJIA. (This thinking led to the recognition that other indices would
be needed.)
Standard & Poor’s 500
Historically, the index that next came into use was the S&P 500, which was primarily
used by institutional investors. This index was designed to correct the acknowledged
problems of the DJIA. First, it had roughly 500 stocks. Second, it used the market
capitalization of the issuer’s common stock for weighting purposes. Standard &
Poor’s is a premier bond rating organization which also covers equities. The company
had an extensive menu of data points that it used to assign credit ratings on
stocks, which it also applied to the S&P 500 Index. Thus, we can now
compare the price of various indices relative to their book values. The S&P
500 Index trades at 5.09 times book value vs 4.08 times for the DJIA. This
comparison highlights the S&P 500 index’s investment in companies perceived
to possess more growth than those in the DJIA.
In my work in analyzing large-cap mutual funds, which have many more assets
than other slices of the mutual fund pie, I use the SPX as the first comparator
before more narrowly using growth, value, and core breakouts. I similarly do the
same for most global funds. Unfortunately, I can’t find enough data rich
breakouts in many local markets, indicating these funds are primarily looking for
local shareholders.
NASDAQ Composite
This 3rd index does not have a size bias. The index is comprised of bank
stocks, local companies, and companies located in various geographic locations,
including Canada, Israel, China, and numerous other countries. Additionally, it
is the initial home for companies recently gone public. Consequently, many of
the stocks on the NASDAQ have limited liquidity due to the low number of shares
offered and/or the founders retaining a significant portion of the stock. It is
not unusual to see 4 or 5 times the number of shares traded on the NASDAQ compared
to the “Big Board”.
The “Market” is Changing
Volume is more sensitive to speculative opportunities than highly rated
investments and it is amplified by the use of derivatives, ETFs, off-market
transactions, and less capital present on the floor. Dow Jones S&P Global is
now the owner and provider of both the DJIA and the S&P 500. Even though
there have been changes, there are still missing elements in market tools.
The separation between stock and commodity markets does not make it easy to
provide a fuller solution to evaluate a uniform portfolio of assets and their risk
modifications in a 24-hour, seven-day world. Agricultural products, impacted by
weather, are important to food manufacturing and distribution industries. Many,
if not most business cycles, are impacted by agricultural disruptions, real or
feared. One of the causes of the great Depression was farm belt problems caused
by excessive debt creation and poor climate conditions. These led to the
passage of the Smoot-Hawley tariff and its global ramifications.
(While agricultural products as a percent of population is
much smaller today than in the 1920s, the global impact may be the same order
of magnitude.)
Moving on to the hard commodities, the timely completion of new mines and
transportation systems can be disruptive to many areas, including stock
markets.
For every global consumer, global producer, shareholder, and military person,
the fluctuating value of major currencies is a cause of concern. This summer
the US dollar dropped from $106.4 to $100.7. (This is likely to have an impact
on inflation)
A Working Conclusion
Indices are a useful snapshot, but what is needed is a continuous motion
picture and an understanding of what is causing the change, including built in
construction biases and an identification of what is missing. If you have any
thoughts, please share them.
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