Did you just hear that crack? That’s the sound of the stock market buckling under the pressure of a Greek bailout, a China hard landing, and a lack of faith in central banks. Both the Dow Jones Industrials and the S&P 500 were down by over 1.5% overnight. Our own Murray Dawes has this to say about the price action:
The technical picture has rapidly deteriorated over the past week. The false break of the April 2012 high in the S+P 500 has now been confirmed. The short term trend has turned down for the first time since the 20th December 2012. We remain in intermediate uptrend so we will still see a bounce from support levels (1320-1340 then 1270-1290) but the opportunities going forward will be shorting this market.
The ASX 200 has now turned down into an intermediate downtrend and has also sent a long term sell signal. There should be some support around 4150-4200 initially but any rally from here should be used as a selling opportunity.
Does the Dow really matter to Australian investors? Not directly. But it does indirectly. The chart below shows you that the index is struggling to breach 13,000 and stay above it. 13,000 is just a number, though. It makes for good headlines. But does it really mean anything? Sort of.
The Dow Jones Industrials Index communicates almost zero useful knowledge about the value of the securities in the index. Remember, there are 30 components in the index. When Charles Dow first set up the index at the end of the 19th century, it was designed to track the performance of industrial stocks within the American economy.
But the DJIA is a price-weighted index. In simple terms, that means higher-priced stocks influence the index average more than lower-priced stocks. We scratched our heads, polled the room, and scratched our heads again. What possible value is there in an index that weights stocks based on share price? After all our research, the answer is: none!
The share price is a function of the number of shares outstanding and the current market value. But why should a high-priced share have more influence over a low-priced share, even if a lower-priced share is for a company with a large market value? It doesn’t make much sense.
The Six Most Influential DJIA Components
The table above shows the top six Dow components by share price. Remember, these shares influence the daily fluctuations in the stock market more than the other by virtue of their high share price. Yet, as you can see, the companies with the highest share price are not the same as the companies with the largest market value.
Exxon Mobil is the largest Dow component by market value, at $410 billion. But it’s only the sixth-largest in terms of share price. IBM, a company half its size by market cap, exercises more influence over the Dow’s daily changes. Based on this, if you wanted to manipulate the Dow and all the indexes linked to it (ETFs), all you’d have to do is manipulate IBM’s share price.
Of course we’re not suggesting that anyone manipulates Dow components in order to goose the index and convey the impression that everything is right with the stock market and the economy. That could never happen. But in theory, you can see how it might be done.
The more important point is that price-weighted indexes overstate the importance and power of certain companies. For example, IBM did $106 billion in revenue last year. That’s not bad. But Exxon Mobil did $486 billion in revenue. You’d think Exxon would be a far more important component to index value.
The even more important point is that most indices are increasingly irrelevant for the individual investor. In the Dow’s case, you can see that it’s no longer an industrial index at all. It has technology companies, food companies, consumer cyclical companies, and financial companies. You can find a complete listing here.
The only original Dow Component that’s still in the index is General Electric. Thomas Edison’s little start-up is a big company now. And in point of fact, the GE Capital Services operating division of the business (the money lending divisions) is at least as important to the company’s earnings as the industrial division. But that’s not our main point.
Our main point is that the issue of survivorship bias is usually brushed under the rug when discussing index returns over time. Survivorship bias is the idea that indices’ historical returns are overstated because companies that fail drop out of the index and new ones are added. In other words, the index only ever measures the businesses that succeed over time.
That measurement – an indices’ performance over many decades – is probably not an accurate reflection of what an active individual investor would get in his investment lifetime. He’d own the winners and the loser. And he’d see that historical index performance statistics probably overstate the historical performance of stocks as an asset class.
What does any of this have to do with Australia? Well the ASX/200 is a market-cap weighted index. That means companies exert influence on the index based on their market value, not their share price. You’d think this would produce a more accurate gauge of the direction of the stock market. In Australia, that means companies like BHP, Rio Tinto, and the Big Four banks exert a lot of influence over the direction of “the market”.
But this is perhaps the most important point of all: individual investors are free to ignore “the market” while professional money managers are not. This gives you a huge advantage. Professional money managers are almost always measured by their relative return. That is, do they do better or worse than the major index benchmark in their given market?
This way of measuring relative returns causes tremendous herding behaviour. Fund managers and portfolio managers with huge amounts of money to invest have a huge incentive to invest in the big index components. That will guarantee them the index return. If they can pick one or two outperformers, they’ll beat the index.
They are also handicapped by the large pools of capital they control. If you have $500 million to invest, you can’t go throwing your weight around in the small-cap market. Your liquidity will distort market caps and share prices by virtue of its size. Your only realistic option is to park your money in the same large investments everyone else is buying.
Greg Canavan pointed this out last week in his weekly update to readers of Sound Money. Sound Investments. Greg quoted from Jeremy Grantham’s latest letter to shareholders in which Grantham asked his readers to recognise the inherent advantage they have over professional investors. Greg wrote:
Being true to yourself is important not only in life. It is crucially important when managing your own money. But as Grantham says, if you do (and have a few basic skills and know your thresholds) you will beat the crowd.
That’s great news. I too think it’s entirely possibly to beat the pros if you can keep your emotions in check.
But I don’t think beating the crowd in the next decade is going to make you rich. It will see your nest egg grow slowly but surely. And I think the SMSI philosophy is well placed to help you get there.
You can read Greg’s latest report to non-subscribers here. But his point is worth repeating: the freedom to act independently and select only the investments you think have a chance for outstanding growth gives you a massive advantage over professional money managers in the coming years.
The pros will be stuck. They HAVE to stay in the market. But risk aversion dictates they have to buy the same basket of stocks. And in any case, the money they control dictates the size of the companies they can invest in. This is why they want you to pay attention to those indices. It keeps the pros relevant by keeping your attention focused on what they want you to see.
But the closer you look, the more you realise the indices tell you almost nothing useful about the economy, about corporate earnings, or about which stocks to buy. The only way to make them useful is to actually trade against them, by using them as a measure of what the crowd is compelled to do. This is part of Murray’s approach in Slipstream Trader (the whole theory of price action is based on analysing the aggregate behaviour of the crowd as expressed in a chart).
To watch Murray’s latest stock market update, go here. It could be his last for a while. The upside of all the index watching behaviour is that these periodic crashes after meaningless symbolic highs help you make money shorting stocks. They also allow you to buy quality companies (value or growth) at exactly the moment no one wants them. That’s your advantage over the crowd.
for The Daily Reckoning Australia
From the Archives…
Carry Trade Currencies and the World’s Most Expensive Cities
2012-03-02 – Joel Bowman
Why the ECB and the Fed Have China Laughing
2012-03-01 – Greg Canavan
Burma’s Economy: The Next Big Story in Asia
2012-02-29 – Chris Mayer
Anatabloc – A Game-Changer in Medical Treatment
2012-02-28 – Patrick Cox
How Australian Banks Use Covered Bonds to Play a Dangerous Game
2012-02-27 – Dan Denning