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What Lies Beneath - Understanding Market Indexes   

With holiday parties kicking into high gear, Michelle inevitably drags me along as her personal arm candy and designated driver.   Finger food and a well drink primes a little idle chit chat that parlays into the predictable ‘what do you do?’  Giving up lying for Advent, my banal response leads to comments about the markets.  While it beats discussing IU sports, it’s at this point I want to sublet DD duties.   But channeling my inner Bob Cratchit, I press forward with minimal snark asking for the specific market they are referencing. Stocks? Bonds? Stamps? Bitcoin?  More times than not, I get the David Puddy stare.[i]  I‘m probably in dire need of a visit from the Ghost of Christmas Future.  Anyway, with a deep breath, I continue…
 
“The domestic equity financial markets have experienced tremendous gains since March 2009.   But all indices aren’t created equal.  They are constructed with different components, styles and methods.  Let’s look at perhaps the most famous of them all: Dow Jones Industrials.  Considering that there are only 30 companies in the Dow, it is too narrow based and basically irrelevant.   But the bigger flaw is the way it’s weighted – price weighted.  This means the absolute stock price, not market cap, has the biggest sway of the index. 
 
Let’s use 2017 as an example.  For the year the Dow is up 24%.  But the high price stocks of just 4 companies: Caterpillar ($144) Apple ($170), 3M ($240) and Boeing ($285), have accounted for almost 60% of this year’s gain.[ii]  What’s interesting about this is Apple’s market cap is more than $800 billion while Boeing has a market cap of around $140B.  Conversely, a more widely held, and larger component like General Electric has lost almost 50% YTD.  But because it is now a $18/share stock, it doesn’t have nearly the effect on the Dow.  More incredulously, there is even talk of booting GE out of the Dow altogether – perhaps replacing it with a more stellar performer like Facebook!  This momentum based, survivorship bias, distorts Dow returns - just 7 stocks make up over 43% of the index.  {At this point, I shared this handy Dow table}
 
Companies in the Dow Jones Industrial Average

Company Price YTD Change
MMM 3M $239.87 34.32%
AXP American Express $98.56 33.13%
AAPL Apple $169.59 46.45%
BA Boeing $282.61 81.12%
CAT Caterpillar $142.59 53.84%
CVX Chevron $119.47 1.72%
CSCO Cisco $37.46 23.73%
KO Coca-Cola $45.80 10.44%
DIS Disney $105.25 1.06%
XOM Exxon Mobil $82.47 -8.58%
GE General Electric $17.75 -43.97%
GS Goldman Sachs $248.24 3.69%
HD Home Depot $182.24 35.59%
IBM IBM $153.67 -7.45%
INTC Intel $43.04 18.58%
JNJ Johnson & Johnson $140.00 21.52%
JPM JPMorgan Chase $104.78 21.39%
MCD McDonald's $172.61 41.78%
MRK Merck $54.88 -6.81%
MSFT Microsoft $82.46 32.68%
NKE Nike $60.65 19.24%
PFE Pfizer $35.47 9.17%
PG Procter & Gamble $90.08 7.10%
TRV Travelers Companies Inc $134.42 9.72%
UTX United Technologies $122.36 11.66%
UNH UnitedHealth $219.91 37.43%
VZ Verizon $50.47 -5.49%
V Visa $111.25 42.59%
WMT Wal-Mart $96.83 40.16%

What about the S & P 500 index?  This is more useful given its 500 company diversity.  It also weights companies by their market cap – larger companies are favored over smaller ones.  But it also isn’t ideal since mid and small cap stocks are marginalized.  So going back to our Apple/Boeing example, Apple would have almost six times the effect on the S & P that Boeing does.   In the Dow, Boeing has nearly twice the weight of Apple.  On balance, the top 10 holdings comprise 20% of the index.
 
Ok, since the Dow is misleading and the S & P also has bulk issues, what would we recommend home gamers follow?  MSCI publishes equal weight indices – might have to poke around to find in Baron’s or the WSJ.  Additionally, there are equal weighted mutual fund and Exchange Traded Funds (ETF) available.   They own publically traded companies of all sizes – from small to mega cap all bundled together inexpensively.  And they are all weighted the same.  Guggenheim Investments specializes in this area.  The one caveat is that equal weighted indices can experience more volatility – especially during market declines.  They don’t have the over-weighted big-boy stocks to buffer broad based sell offs.  For example: in 2008, market weight was down 37% while equal weight was -42%.
 
And none of this even considers the sector weightings.   Given that the S & P’s top 4 holdings are now Apple, Microsoft, Amazon and Facebook, you could say technology is more than well-represented.  I guess my point is to look under the hood of any investment to see what it’s holding and determine if it reflects your investment objectives.  But I digress; what do you do?”  

 
I take a babble break.  It was at this point I realized I have the social appeal of a whisk broom.  My fellow party goer slid away blowing bubbles to himself – using my Dow table as a napkin.  But that’s ok - I was firmly in the Christmas spirit - ask and ye shall receive!  Perhaps I deferred that ghost visit for another year.
 
Fiscal Fitness is a publication of Houlihan Asset Management, LLC for the benefit of its clients and friends.     Houlihan Asset Management.  Wealth Counseling/Asset Management. Copyright 2017

 

[i] Fictional Seinfeld character.

[ii] Isbitts, Following the Dow? There’s Something You Should Know, Forbes, October 2017