Investment Update: September 22, 2020 - Measuring the Markets
First, it would be helpful to review a part of our September 4th market comment:
The markets have had an impressive climb from their lows in March… It is a natural pattern for the markets to retreat as Wall Street takes profits after a big market move. We have often mentioned the normal patterns of the markets include two steps forward and one step back. Sometimes it is ten steps forward and four or five steps back, which is normal.
… Should this brief sell-off accelerate, a total short-term market decline in the Dow Jones Industrial Average of minus 6% to 10% would be a reasonable area to watch, and perhaps a minus 10% to 15% on the technology heavy Nasdaq.
If the Dow continues to retreat, we estimate that another 4.5% to the downside would remain a normal expectation. The tech heavy Nasdaq may expect a further decline of 5.2%.
As we have often noted, the three most widely recognized indexes known to investors are the Dow Jones Industrial Average©, the S&P 500©, and the Nasdaq Composite© and each have certain values in measuring their respective market area. They are also widely misunderstood as proxies for measuring the success of long-term investors. We would like to highlight just a few of the many aspects of how these indices work. To start, let’s discuss the overlap in stocks across each of these indices.
All thirty stocks that comprise the Dow are also included in the S&P 500. Six of the thirty Dow stocks trade on the Nasdaq and comprise seventeen percent of the Dow’s index weight. The Nasdaq is heavily weighted towards the technology sector with over fifty percent in this one economic sector.
The calculation of how each index is valued differently: The Dow stocks are weighted by price, meaning that the higher the stock price, the more it affects the Dow’s value. The share price of a company by itself has no bearing on the actual value of the company in this index.
The S&P 500 consists of 500 stocks and is weighted by market capitalization which means that the largest stocks have a larger effect. The largest twenty stocks account for almost thirty five percent of the 500-stock index.
The Nasdaq is dominated by technology and specifically the “FAANG” stocks – Facebook, Apple, Amazon, Netflix, and Google. These five stocks dominate both the Nasdaq and the S&P 500 and by themselves account for most of the recent market rise.
The Dow and the S&P are managed by committees and are not static indices. For example, last August, Amgen, Honeywell, and Salesforce.com were replaced by ExxonMobil, Pfizer, and Raytheon Technologies in the Dow. That is a 10% turnover, therefore, there should be some consideration of the full value of a particular index in measuring long-term goals.
Finally, all three of these major indices profit from the use of their names and index composition. For example, the Dow Jones Industrial Average and the S&P 500 are privately owned by the same company. The licensing of these indices to mutual funds, exchange-traded funds and other financial products generate almost half a billion dollars in yearly revenue. There are thousands of indices measuring every aspect of markets and financial instruments around the globe.
One may question the continued use of index information in our Investment Updates, including this one, since we began with our views of the market with the Dow Jones Industrial Average as a reference. Simply put, we do not find fault with the indices if the pros and cons are understood. They are common points of reference for all investors and therefore useful communication tools. As often mentioned, one of my favorite quotes is from Benjamin Disraeli …” There are lies, damn lies and statistics”, which is a perfect quote for the financial industry.
As always, please feel free to discuss this Update or anything on your mind. We appreciate the opportunity to serve you.