Understand Numbers Before Using - Weekly Blog # 851

 

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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Ignore Short-term Headlines, Invest for the Long-Term

Pundits focusing on the individual investor and the independent voter proclaim the pains of uncertainty. They explain the lack of attention to the shortage of retirement funding throughout the world. Compared with their appetite for stocks over the last generation, individual investors’ purchases of equity mutual funds beyond their tax-sheltered retirement plans is pathetic. Capital growth is not their answer to recognized long-term needs. Capital preservation through the ownership of bonds is where their smaller-than-normal excess investment dollars are going. The low apparent inflation rate is not a concern for them.

Upbeat notes

In contrast, the non-committee focused professional investor is becoming increasingly attracted to equities and equities with coupons known High Current Yield bonds, or if you will junk bonds. Their purchases are providing the upward momentum we have seen since the dog days of August. They are being reinforced by strategic and financial acquirers’ announcements or rumors.

One of our advantages in helping sizeable institutional and substantial net worth investors in mutual funds is that we talk with lots of very smart and aware portfolio managers and analysts. Without exception they expect better revenues and earnings to be generated by their investments than past comparisons. (To be fair, some are moderating their estimates for 2011, but still see them higher than their 2010 estimates.) Occasionally we supplement this research by interviewing operating corporate executives who report that business is better than in the recent past and that their order books are getting fatter. As many members of this blog community know, my wife Ruth and I regularly check-out one particularly glitzy mall and other stores. There is a discernable “buzz” in the air as we see more shopping bags leaving the mall on the arms of many different types of consumers.

Three upcoming events

“Beauty is in the eye of the beholder” is an old expression that the viewer sees what he or she wants to see. There are three opportunities that will give consumers/investors an opportunity to use their dollars to express whether these events are viewed as good or bad for them.

The US elections

The first will be the results of the mid-term US elections, which may lead to significant changes in the critical unelected, but extremely powerful staffs on the various Congressional committees and to some extent the so-called independent agencies. One might suggest that the stock market rise since Labor Day is discounting the favorable change. The second and third events are somewhat interrelated.

Attempts to manipulate Balance of Payments

The second item is the government's attempted manipulation of balance of payments among the countries of the world. If this practice was done in the private sector it would be illegal. The US government wants to create an artificial ceiling to the size of balance of payments surpluses (read: limit the size of the US balance of trade deficit). We know the reality of international trade, that constraints do not work. In the historic example of the Smoot–Hawley Tariff of 1930, enacted by a panicked US Congress, the world was plunged into a depression from a severe recession. The futility of limiting trade is evidenced by the fact that during almost every war in recorded history, the opposing sides traded with each other through third parties.

Gold vs. paper currencies

The third event or events is the pattern of learned experts predicting that the price of gold will rise to $1500, $2200, and $10,000. This is the wrong way to look at the price of gold according to a very smart friend of mine who has headed two major research departments. His contention, along with others, is that the price of gold is a contrary indicator which measures the decline of the value of paper currencies, led by the dollar.

The link between the government attempts to manipulate trade flows and the decline in the value of paper currencies is the governments’ induced inflation. When people trade using currency (as distinct from barter), on one side of an international trade, both the amount and the value of the currency play a role in setting price. The US along with many European governments is trying to answer unemployment problems by the injection of taxpayer funds to support the economy through the expansion of debt.

In November we will learn about the election, the ill-advised quantitative easing by the Fed (discussed in my blog last week), the meeting of the G-20 leaders, and the likelihood of further legislative actions in the “rump’ session of the US Congress. Whatever actually happens, the key to the near-term outlook for the stock market is what beauty will investors, particularly individual investors behold in the post-November world?

What to do?

What should intelligent long-term investors do in the face of the November issues? I would suggest that you ignore all of the headlines and focus on building a portfolio that is appropriate to your needs for at least the next ten years. Over that period we will get one or more major winds to fill our sails. This wind will give us ample opportunities to jettison any poor investments that we have made and to rebuild our reserves for future storms. Sail on...
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