Into the Unknown With a Moto Guzzi, the Dow Jones, and the S&P 500

It has been years since we have seen new highs on the Dow Jones Industrial Average and the S&P 500.  Although the wait can be traumatizing, it’s nice to get proof that market prices ultimately recognize growth of business value.   

With record highs, a lot of you may be experiencing a little anxiety.  I can’t blame you for that, but I can try to give you a little relief in hopes that your anxiety doesn’t lead to a full blown panic attack.  My own anxiety does not come from the markets, but from realizing how time flies!  I still remember thirty years ago when I watched the Dow Jones reach a new high; closing the year of 1982 at 1046.54. How can thirty years go by so quickly? 

Today, there are multiple market pundits telling us that the markets cannot go higher from these levels.  The pundits said the same thing 30 years ago and I am glad I turned a deaf ear to them then.  You see, every dollar I invested in common stock in 1982 has grown far greater than 14 times.  Of course, looking backwards, it is pretty easy to live with the results.  I am just happy that we humans can not only remember the good times, but can easily forget the trauma of the past.  Over the past thirty years there have been many occasions where my own anxiety wanted me to desperately stop the pain and sell every common stock I owned.  I am glad I didn’t.

I have noticed that investors, both individual and professional, will reference the Dow Jones and the S&P 500 as measures of value and performance without any real understanding of how these indices are constructed.  They may tell me the Dow is 30 blue chip companies and the S&P is the 500 largest companies in America.  Some will tell you they are unmanaged indices and most will use these indices as a benchmark to judge how well they are doing.  Of course none of these descriptions are accurate, nor should most of you use them as a benchmark, especially the Dow.  So this month I thought I would spend a little time to help you understand these major indexes, how they are put together and by whom.   More importantly I want to give you a few reasons why you should not rely on them as a benchmark to determine how well you are doing.

But before we get into the discussion of market indexes, I want to take you on another trip into the unknown with the Moto Guzzi.  You can learn a lot about this country through travel.  But you can’t get a good feel for how large and dynamic our country is in a plane at 35,000 feet.  Traveling by motorcycle puts you up close and personal to the land, the cities, and most importantly to the people.   

As most of you know, my wife is a School Psychologist.  As with all health professionals, continuing education is important to update their knowledge with current advancements in their field.  Kathy attends numerous conferences throughout the year to make sure her knowledge is current. To maintain her license, she is required to do a certain amount of hours of study.  This year she could obtain all of the required hours by attending the National Association of School Psychiatrists national convention which was held in Seattle Washington the week of February 11th.  Being with Kathy on Valentine’s Day was all I needed to get on the bike and make a trip.

The weather in February didn’t allow me to take the direct route through the Midwest and across the northern great plain, so I took a southern route.  Let me tell you, the weather in the south was almost as rough.  Of the 7,400 miles I traveled, only about 100 were nice, with 65 degree temperature and the wind at my back.  And for those Midwestern farmers who think that snow never falls in southern Arizona beware.  I can tell you from experience that is a myth!

The trip out was fast with stopovers in Rustin, LA, Las Cruces, NM, Barstow, CA and Medford, OR.  The return trip had stopovers in different places but about the same distance apart.  The average temperature was mid forties, with lows in the twenties and highs in Southern California of mid sixties.  The rain and wind were my companions.  With frequent stops for fuel and to stretch my legs I had the chance to visit with people who truly represent the makeup of our country. 

Every small town has something special about it that their people will proudly share with visitors.  They are, for the most part, friendly, happy and optimistic about their future with almost no discussion of how tough it is to make a living.  Although the people I visited with in the major metropolitan areas seemed to share the same friendliness and optimism, once they found out I was from South Carolina, they were quick to tell me their stories about the time they traveled to or through our state or wished to be able to make a trip like mine.  Of course this was almost always followed with a mention of how they just can’t afford it right now. 

After visiting with so many individuals from eleven states I can share with you some anecdotal evidence about the state of our economy and the future.  Our economy is not as bad as our politicians or media sources make it out to be.  The people who live, work and raise their families in America tell me that it is a little tough right now, but they are also quick to say their future is great.  As an investor, the future is what is important.  The people have every desire to make a better future for them and their families no matter what the politicians throw their way.  I am betting they will succeed and will tell all of you whose investment time frame is more than a day, a week, or a year, that betting against them is a big mistake just as it was thirty years ago.

The Dow Jones Industrial Average

The Dow Jones Industrial Average is the granddaddy of stock market indices.  It is the one most mentioned by the financial press and probably the one you follow when trying to determine the health of the stock market.  It was created by Charles Dow and his associate Edward Jones way back in May of 1896.  No doubt the index was created to add a little circulation to the duo’s Wall Street Journal Publication.

The process was pretty simple.  They decided on averaging the price of ten blue chip companies and reporting this average price as a single number.  Every day, as the prices changed, the average price would also change.  By comparing one average to another you could quickly recognize whether stock prices were advancing or declining.

At the turn of the 20th century blue chip stocks did not have the same meaning as they do today.  Then, they were stocks whose dollar price per share was high, just like the blue chip was the highest price gaming chip at the gambling tables.  Of course, today, blue chips have a different meaning; a large company with a sterling reputation that will be profitable in all economic situations.  The Dow has expanded to 30 stocks most of which do meet the current definition of “blue chip” but it is by no means a requirement to be included as one of the Dow 30.

The committee that selects the Dow constituents is, for all practical purposes, simply a portfolio manager. But there are reasons why the Dow is not a good judge of the “market”. First, it is constructed using only 30 U.S. stocks in a market of 25,000+ world-wide.  Far more important is that the index is price weighted, meaning the highest price impacts the results more than a lower price stock.   Take IBM and Microsoft, both are included in the Dow.  IBM’s market value is $233 Billion and Microsoft’s is $241 Billion just slightly more than IBM’s.  IBM’s share price is $210.00 while Microsoft’s is $29.00.  Because IBM’s share price is 7x greater than Microsoft, it is considered 7x more important than Microsoft and will impact the index’s value by that same 7x.  If IBM and Microsoft are about the same size and in the same industry, shouldn’t they have the same impact?  Price weighting gives no weighting to the size or importance of the company.

There is a second problem that causes long term problems with a price weighted index.  When a company splits its shares or pays a stock dividend, the number of shares outstanding will increase and the price of the shares will be reduced.  For example, if one of the Dow 30’s share price is $100 and the company splits its shares 2 for 1, the number of shares will double and the stock price will be $50.00.  You notice there is no change in total market value of the company, thus there should be no impact on the index.  But because the share price was cut in half the average price of the 30 stocks would decline, even though the values of the companies have not changed at all.  To correct this, a little math is required.   The keepers of the Dow just need to find a number, that when divided into the index’s average, adjusts the index value to make it look as if the split never even took place.   Sounds easy, but what about when we look many days into the future?  If the price was $100 and now it is $50, the divisor will only have fixed the problem with the index on day one.  In the future, that $50 will always have less importance than another company priced at $100. 

Because of habit and history the Dow will continue to be the primary indicator of the stock market for the media and the majority of Americans.  Now that you know a few of the problems in how the Dow is constructed, maybe you will be less inclined to use this index as a benchmark for your own returns.

The S&P 500

The S&P 500 is the second most popular stock market index.  Over time the media will in most instances mention the Dow average first followed by the S&P 500.  As in its name, the index is based on the market capitalization of 500 leading companies whose country of origin is the United States.  The 500 companies are selected by a committee from the same folks who control the Dow; S&P Dow Jones Indices a division of McGraw Hill Companies.

Way back in 1923 Standard & Poors introduced a stock market index based on the market value of 90 leading companies in multiple industries calculated and reported daily.  At the same time they calculated a value weighted index of 423 other companies but only published the index value on a weekly basis.  In 1957, Standard & Poors began calculating and reporting the S&P 500.  Because the index is weighted by market value, and the 500 companies included in the index represent approximately 75% of the total stock market value for U.S. companies, it is a much better indicator of the general level of stock prices than the Dow.  Unlike the price weighted Dow, the market cap weighted index does overweight the more valuable companies than the less valuable companies.

The S&P 500 does have a few problems.  Probably the most important is the claim that because it is based on the total market value of its constituent companies, it gives far more weight to the most popular companies and less weight to the companies most out of favor with investors.  There is some truth to that.  Buying the index puts more of our investment money in those companies that could very well be overpriced.   

Just like the Dow, the S&P 500 only includes U.S. companies.  At one time this was not necessarily a problem as the U.S. stock market dominated the world.  Not so today.  As we mentioned, there are approximately 25,000 investible companies throughout the world.   However, this problem is lessened by the fact that close to 40% of the revenues and profits generated by the S&P’s companies are generated outside the U.S..  

Benchmarking

In years past, you could use the change in the S&P 500 to measure your own results or make a judgment of your manager’s portfolio management capability.  Over the years, a couple of things have changed that cause us to question whether you still can.  A number of years ago our regulators decided that every mutual fund or portfolio manager had to compare the returns of their funds to an index.  A few years after these rule changes, managers that outperformed their chosen index started receiving new money.  Those that did not watched as clients pulled money from their funds and sent the funds off to the winning managers.  The time frame used to compare results of the good managers to the bad managers dropped from ten years of history, to five years of history, to three years of history, and then, to one year of history.  In other words, if you as a manager did not outperform your index, year by year your clients left you and your income stopped.   

Well, managers quickly learned that they need to at least come close to the returns of the index or they will lose some clients.  The easiest way to accomplish this was to just build a portfolio that matched the index or do just the opposite.  Build a portfolio that looked nothing like the index, take a huge risk in hope that you could win big and get a bunch of new clients.  Today we live with the results.  If you want to succeed as an investment company you can manage an index fund based on well know indices and if that doesn’t work you just create a new index or manage a hedge fund.

S&P Dow Jones calculates 830,000 indices.  Yes that is right, 830,000 indices.  It looks like the investment business has adapted this new tag line: “if you can’t beat ‘em, just create a new one that you can beat”.  We have talked about this in our planning meeting.  We came up with something I think is a guaranteed winner.  We will create an index based on the market value of the South Carolina inch worm.   We South Carolinians spend a huge amount of money, time and effort to sweep away those pesky critters.  Since it costs money to meet our goal of inch worm elimination and the value of inch worms is questionable, the index would never be higher, just lower.  We would never have to make a profit for anyone, yet we would still be considered winners.   Because we would beat the index on any year we had a profit I could assure our company that we would have a continuous stream of new clients referred by consultants and mutual fund salesman from all around the world.   I wonder if S&P Dow Jones will construct the South Carolina Inch Worm index for me.  With 830,000 indices, one more is no big deal.

I am sure the habit of comparing returns to an unmanaged index will continue for years into the future.  I am hoping that you will recognize that this is not the best way for you to judge how your own portfolio is doing.  In August of 2010, I wrote 10 Steps to Improve the Returns of Your Portfolio based on a paper written by Dr. Paul Woolley.  Step 4 – Adopt a stable benchmark such as growth of GDP plus a risk premium.  It is worth repeating:

A benchmark used by the majority of institutional investors is simply a targeted return that has its base in the relative performance of asset classes.  For you, mutual fund companies and in many cases your advisor has incorporated this benchmark approach.  A target date fund with a fixed percentage of your portfolio in stocks, bonds and cash based on your age is one example.  Your advisor may incorporate this by creating an “investment policy statement” allocating your portfolio over various asset classes with predetermined rebalancing dates.  For most of us, a benchmark to a set asset allocation is unimportant.  What is more likely is that our benchmark is liability driven.  These liability driven benchmarks are stated as goals, such as having enough money available to pay for a wedding or a college education.  For others it is an unknown quantity so an arbitrary benchmark is set, usually stated as a rate of return earned over a long period of time.  Most of us are pretty good at setting our benchmarks.  What we are not good at is keeping those benchmarks on the top of our minds when we make changes in our investment accounts. 

Most of us need some kind of benchmark.   We can choose to use an index, or, we can recognize that they have lost their meaning for us as individuals and adapt a useful benchmark that is goals based.

Until next time,

Kendall  J. Anderson