Unlike the Dow Jones Industrial Average, the Standard & Poor’s 500 stock index (^GSPC, commonly referred to as the S&P 500) is a value-weighted index. The index was 10 in the base year, 1943. Thus, if the index is currently 100, the value of these
fIGuRE 10.2
The Use of Different Scales to Illustrate Stock Price Movements
$25 20 15 10 5
Month Jan Feb Mar Apr
Price
$80 40 20 10 5
Month Jan Feb Mar Apr
Price
Source: © Cengage Learning
stocks is ten times their value in 1943. Standard & Poor’s also computes an index of 400 industrial stocks and indexes of 20 transportation, 40 utility, and 40 financial companies.
Since the S&P 500 is a value-weighted index, large capitalization stocks such as Microsoft and ExxonMobil, whose market values were $274 billion and $328 billion as of January 2010, have more impact on the index than Alcoa, whose market value was $15.2 billion. Although the number of stocks in the S&P 500 remains constant, the composition of the index changes over time. Mergers and acquisitions are one cause of changes in the index as a firm is acquired and is replaced in the index by another stock. A financially weak firm whose stock has experienced a major decline in value may be dropped in favor of a company in better financial condition. Also, if the market value of a company declines, it may be dropped from the index and replaced by a stock with a larger capitalization. For example, McDermott International was dropped and MedcoHealth Solutions was added. The reason given for the switch was the decline in McDermott’s market capitalization.
fIGuRE 10.3
Annual Price Range of the Dow Jones Industrial Average, 195022011
1980 1975 1970 1965 1960 1955 1950
Year 12,800
6,400 3,200 1,600 800 400 200 100
1995 2000 2005 2010 1990
1985 25,600
2015
Source: http://stockcharts.com/freecharts/historical/djia1900.html.
The impact of price of the stock that is added is usually positive. Any increase, however, is not the result of the company receiving favorable recognition but of buying by the index funds, which must now include the stock in their portfolios. Conversely, if a firm is dropped from the index, the index funds will sell their positions, which may cause the price of the stock to decline.
The S&P 500 is essentially an index of large cap stocks. Standard & Poor’s also has an index of 400 moderate-sized firms (the S&P 400 MidCap index, ^MID) and an index of 600 small firms (the S&P 600 SmallCap index, ^SML). There is also an index (the S&P 1500, ^SPSUPX), which combines all the stocks in the S&P 500, the S&P MidCap, and the S&P SmallCap indexes. (For information on the S&P indexes, go to www.standardandpoors.com.)
The New York Stock Exchange Composite Index (^NYA) includes all common stocks listed on the NYSE. Like the S&P 500, the NYSE Composite Index is a value- weighted index. In 2002, the NYSE reconstituted the index to include all common stocks, American Depositary Receipts (ADRs) of foreign stock traded on the NYSE, and real estate investment trusts (REITs), and to exclude preferred stocks, closed-end and exchange-traded funds, and derivatives. (Each of these types of securities is covered in various places in this text.) The index’s base was changed from 50 to 5,000 starting as of December 31, 2002. Returns on the index are reported for both price changes and for price changes plus dividends. (For information on the NYSE Composite Index, and other NYSE indexes, go to the NYSE webpage: www.nyse.com.)
The Value Line Geometric index (^VLIC) of approximately 1,700 stocks differs from the Dow Jones, S&P, and NYSE indexes in two important ways. It includes the stocks covered by the Value Line survey. This coverage encompasses stocks that are traded on the NYSE and on Nasdaq but are not necessarily in the Dow Jones Industrial Average and the NYSE Composite Index. Since some of the stocks covered by Value Line are not large cap stocks, they are excluded from the S&P 500 even though they may be in the S&P 400 and the S&P 600. The second important difference is the method of calculation.
Value Line uses a geometric average that gives equal weight to each stock included in the average. The Dow Jones Industrial Average and S&P indexes are arithmetic and value- weighted averages. (Value Line also publishes an arithmetic average, ^VAY.)
Other aggregate measures include the Russell indexes and the Nasdaq index. The Rus- sell (^RUI) consists of the 1,000 largest U. S. companies traded on the NYSE and on Nas- daq. Largest is measured by market capitalization, and all of the stocks in the Russell 1000 have a capitalization exceeding $1 billion. (The average capitalization is approximately
$80 billion.) The Russell 2000 (^RUT) consists of the next 2,000 largest U.S. companies based on capitalization, and the Russell 3000 (^RUA) combines the stocks in the Russell 1000 and the Russell 2000. The Nasdaq Composite Index (^IXIC) of over-the-counter stocks covers more than 3,000 issues. Perhaps the broadest-based aggregate measure of stock prices is the Wilshire 5000 (^DWC), which is constructed using most of the stocks traded on the NYSE and Nasdaq (i.e., virtually every publicly traded U.S. company).
While the name implies a total of 5,000 stocks, the actual number exceeds 5,000.
Specialized Indexes
The previous section considered aggregate measures of the market or measures based on the size or capitalization of the company. The S&P 500 and the NYSE
Composite Index are obviously aggregate measures that emphasize large cap stocks, and the Dow Jones Wilshire 5000 is a very broad-based measure of stocks. In ad- dition to these aggregate measures, there are many averages and indexes based on specific subsections of the market. Initially, Dow Jones computed not only its indus- trial average consisting of 30 stocks but also averages for 20 transportation stocks (^DJT), 15 utility stocks (^DJU), and an aggregate average of all 65 stocks (^DJA).
In recent years, Dow Jones has developed specialty measures for industries such as Composite Internet (^DJINET), individual countries (e.g., the Dow Jones Japan Titans 100 Trust, ^XLJNTR), or world markets (e.g., Dow Jones Asia/Pacific Large Cap, ^P1LRG).
Specialized market measures are not a monopoly of Dow Jones. Standard & Poor’s has indexes based on economic sectors. Each stock in the S&P 500 is classified into one of ten sectors based on the firm’s largest source of revenue. In reality there are a large number of indexes that cover the subsets of the securities markets. This large number of specialized measures means that the individual investor, financial analyst, or portfolio manager can monitor market movements in virtually any desired area. Information on a particular index is readily available through Internet sources such as Yahoo! Finance or Google Finance. Use the ticker symbol to access a particular index.
With perhaps the exception of the Dow Jones Industrial Average, the individual investor cannot purchase all the stocks in an aggregate measure of the market. The indi- vidual investor, however, can acquire shares in an exchange-traded fund that replicates an index. For example, The iShares Russell 1000 (IWB) tracks the Russell 1000 and the Vanguard FTSE AW ex-US ETF (VEU) tracks an index of world stocks excluding U.S.
companies. These ETFs, however, need not acquire all the stocks in the specific index.
Instead they establish positions that replicate the index and hence provide the investor (before expenses) the return indicated by the benchmark index.
While it may seem unnecessary to have so many indexes (and obviously an individ- ual cannot follow all of them), each index can serve an important purpose. In Chapter 6 on mutual funds, assessing a portfolio manager’s performance requires a benchmark for comparison. While a large cap growth fund may be compared to the S&P 500, such a comparison would not be appropriate for the manager of a fund that specialized in energy stocks or small cap stocks. This question of comparability applies to any spe- cialized investment portfolio. If assessment is to be based on market comparison, then appropriate measures of the relevant market’s performance are necessary. Certainly the large number of indexes serves this purpose.
The individual investor, however, should be aware of a potential weakness. With so many aggregate measures available, a portfolio manager may be able to find an index that puts that manager’s performance in a favorable light. If, for example, the S&P 500 indicates inferior performance but the Wilshire 5000 indicates superior performance, an obvious incentive exists for the portfolio manager to use the Wilshire 5000 when reporting performance comparisons. Switching from one index to another may be a red flag and certainly should raise a question concerning the validity of the comparison.
Of course, if the portfolio manager is consistent and uses the same index for several consecutive years, there may be periods of underperformance. The efficient market hy- pothesis suggests that such performance may be expected, since consistent superior performance is hard to achieve.
Sector Indexes
In addition to aggregate indexes of the market, there are indexes of economic sectors.
There are, however, differing definitions or compositions of the sectors. The following list provides the sectors as enumerated by Dow Jones, S&P, and Morningstar.
Dow Jones S&P Morningstar
Basic materials Basic materials Industrial materials
— Communication services Telecommunications
— — Media
Consumer goods Consumer stables Consumer goods Consumer services Consumer cyclicals Consumer services
Financials Financials Financial services
Health care Health care Health care
Industrials — —
Oil and gas Energy Energy
Technology Technology Software
Transportation Transportation —
Utilities Utilities Utilities
— — Hardware
While there are obvious overlaps, the compositions of the sectors do differ. For example, both S&P and Morningstar have an energy sector but the Dow Jones version is limited to oil and gas. This implies that firms included in the indexes will differ, so there is no reason to assume perfect correlation exists between the compositions of the sectors.
The existence of ETFs means that the investsor may take a position in a specific sec- tor without having to purchase individual stocks of companies in the sector. If the inves- tor believes that economic expansion will result in higher returns for consumer staples, that individual does not have to buy stock in Coca-Cola or Kraft Foods. Instead the investor may purchase shares in the Vanguard Consumer Staples Index Fund (VCSAX).
And the same applies to the Vanguard Health Care Index Fund (VHCIX), which has positions in Merck, UnitedHealth Group, and Amgen.
Aggregate Measures of Stock Prices and Correlation
As may be expected, the correlation between aggregate measures of the American stock markets is high. This is illustrated in Figure 10.4, which plots the Dow Jones Industrial Average, the S&P 500, and the NYSE Composite Index for 198022000. (The Dow Jones values have been divided by 10 to put them on a common basis with the other two indexes.)
By visual inspection, the correlation between the aggregate measures appears to be high. The correlation of the monthly price changes for the data used in Figure 10.4 for the S&P 500 and the NYSE Composite Index is 0.99. Merrill Lynch Quantitative Analysis estimated the correlation coefficient relating the S&P 500 and the Dow Jones Industrial Average to be 0.95, and the correlation coefficient between the S&P 500 and the NYSE composite approximated 1.0. The NYSE reported that the correlation between its index and the S&P 500 was 0.968.
Bond Averages and Indexes
In addition to stock indexes, there are also aggregate measures of the bond markets.
These averages and indexes differ from stock indexes in several ways. The first is the units. Bond averages may be expressed in terms of yields instead of prices. This is illustrated in Figure 10.5, which presents the Dow Jones 200 bond composite and the yields on Moody’s Aaa-rated bonds for 197822000. The average is expressed in dollars and the yields are in percentages. The figure vividly illustrates an inverse relationship between bond prices and yields. For example, the bond average declined from 85.4 to 55.4 between January 1979 and September 1981 when yields rose from 9.3 percent to over 15 percent. Then yields started to decline and bond prices rose. This pattern con- tinued into the 2000s when bond yields were at lows not seen in decades. (This negative relationship between interest rates and bond prices is explained in Chapter 14 on the valuation of fixed-income securities.)
Measures of the bond markets that are expressed in terms of yields are obviously not comparable to stock indexes such as the S&P 500, which are based on prices. Even mea- sures of the bond markets that are expressed in terms of price may not be comparable to measures of stocks. Instead of experiencing the price appreciation associated with stocks, bond investors collect interest payments. Their return primarily consists of the flow of fIGuRE 10.4
Aggregate Measures of Stock Prices, 198022000 1600
1400 Dow Jones
Industrial Average
Standard & Poor’s 500 Stock Index
New York Stock Exchange Composite Index 1200
1000 800 600 400 200
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
0
Source: Federal Reserve Bulletin, various issues.
One means to overcome this problem of comparability is to select a starting point such as January 200X and then use the price plus the interest that is earned and rein- vested. Over time, the value of the bond average should increase as the interest com- pounds. The Dow Jones corporate bond index has been reconstituted to include the reinvestment of interest payments, so the bond average is more comparable to the Dow Jones stock averages.
As with stock indexes, there are aggregate measures of the bond market in addition to the Dow Jones bond average. A sampling of these measures for U.S. Treasury debt and their ticker symbols is as follows:
30-year Treasury Bond ^TYX 10-year Treasury Bond ^TNX 5-year Treasury Bond ^FVX 13-Week Treasury Bill ^IRX
You may easily access these indexes by using an Internet source that provides stock prices and entering the ticker symbol. Bond indexes for corporate debt include Barclays aggregate bonds (AGG), Barclays high-yield bonds (JNK), and Barclays Asia bonds (AGZ). You may readily buy and sell exchange-traded funds that track these indexes.
fIGuRE 10.5
Dow Jones Bond Average and Yields on Mergent’s (Moody’s) Aaa-Rated Bonds, 197822000
90.0 80.0 70.0 60.0
Year 15.0%
14.0 13.0 12.0 11.0 10.0 9.0 8.0
Average Yields
Average Yields
Dow Jones Bond Average Dow Jones
Bond Average
7.0 6.0 100.0
110.0
1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 Source: Moody’s Bond Record, various issues, 197821999; Mergent’s Bond Record, various issues, 2000; The Wall Street Journal
Index (Ann Arbor, MI: UMI Company), 197822000.
The Volatility Index (VIX)
One index that has received considerable publicity during the recent financial crises is the Volatility Index, which is commonly referred to by its ticker symbol: VIX. (Use
^VIX to obtain values of the index.) The VIX is a measure of investors’ expectations or “sentiment” about near-term stock market volatility. Since the VIX is a gauge of in- vestor expectations, it also measures market psychology and is often referred to as the
“fear” index.
The actual calculation of the VIX is based on the S&P 500 index options and is expressed in percentages. (Options are explained in Chapters 17 and 18.) For example, a numerical value of 20 suggests that market participants expect the S&P 500 to swing by 20 percent over the next 12 months. Low values such as 10 suggest little volatility;
market participants are not pessimistic or are even complacent. As they become more pessimistic and the stock market becomes more volatile and less certain, the value of the index rises. A value of 50 suggests an expectation of large swings in the S&P 500.
During 200522006, the value of the VIX fluctuated between 10 and 18 and re- mained in that range through July 2007. As financial problems started to emerge and people became more aware of them, the VIX rose. By January 2008, the index had risen to over 38 and continued to increase through the year. During October, the VIX rose from 39 to a historic 89 in a matter of days and ended the month at 55. As the financial crises started to recede, the VIX also declined and by 2012 stood at 23.
Case-Schiller Home Price Index
While not directly related to investing in securities, the Case-Schiller Home Price Index is often mentioned in the financial press to document trends in home prices. The index is based on sale prices of existing single family homes for urban areas. In addition to the aggregate index, Case-Schiller also reports a ten city index and individual indexes for each of the twenty urban housing markets.
The Case-Schiller Home Price Index clearly documented the large increase in home prices experienced during 2000 – 2006 and the subsequent price decline. From a base of 100 in 2000, the index rose to 189 in 2006, an increase in excess of 89 percent. The index subsequently declined to 130 in 2011. While not all home prices rose and fell so dramati- cally, the index clearly documented the rapid increase and decline in housing prices.