Chapter 7 SECURITYMARKET INDICATOR SERIES Chapter 7 Questions

Chapter 7 SECURITY-MARKET INDICATOR SERIES

Chapter 7 Questions What are some major uses of security-market indicator series (indexes)? What are the major characteristics that cause alternative indexes to differ? What are the major stock-market indexes in the United States and globally, and what are their characteristics? What are the major bond-market indexes for the United States and the world?

Chapter 7 Questions Why are bond indexes more difficult to create and maintain than stock indexes? What are some of the composite stock-bond market indexes? Where can you get historical and current data for all these indexes? What is the relationship among many of these indexes in the short-run (monthly)?

What is an indicator series? It is an index that answers the question: What happened in the market today?

Uses of Security-Market Indexes For calculating benchmark returns to judge portfolio performance For development of an index portfolio For examining factors that influence aggregate security price movements For technical analysis, to predict future price movements To compute a security’s systematic risk by examining how its return responds to changes in the market index

Factors in Constructing Market Indexes The sample of firms to include l What is the intended population that the sample is to represent? How large a sample is needed for the index to be representative? Weighting system for sample members l Should the weighting system be based on price, total firm value, or equally weighted? Computational procedure l How should the values of the index be reported and tracked (arithmetic or geometric mean)?

Stock-Market Indicator Series Price-Weighted Series l Dow Jones Industrial Average (DJIA) Value-Weighted Series l l NYSE Composite S&P 500 Index Russell Indexes Willshire 5000 Index Equal-Weighted Series l Value Line Averages

Dow Jones Industrial Average (DJIA) Best-known, oldest, most popular index Price-weighted average of thirty large wellknown industrial stocks, leaders in their industry, and listed on NYSE Total the current price of the 30 stocks and divide by a divisor l l Original divisor was 30 Divisor now adjusted for stock splits and changes in the sample, so now much smaller (about 0. 1445 in March 2002)

Criticism of the DJIA Sample used is limited l 30 non-randomly selected blue-chip stocks are not representative of the 1800 NYSE listed stocks Price-weighted series l l l Similar to assuming an investment of one share per stock Places more weight on higher-priced stocks rather than those with higher market values Introduces a downward bias in DJIA by reducing weight of growing companies whose stock splits

Value-Weighted Series Although the DJIA is the most popular index, the most popular type is value-weighted. Derive the initial total market value of all stocks used in the series Market Value = Number of Shares Outstanding x Current Market Price Beginning index value is usually 100, new market values change the value of the index Automatic adjustment for splits Weighting depends on market value

Value-Weighted Series where: Indext = index value on day t Pt = ending prices for stocks on day t Qt = number of outstanding shares on day t Pb = ending price for stocks on base day Qb = number of outstanding shares on base day

Value-Weighted Series Construction similar to assuming investment in proportion to total market value Take into account that large market value stocks make up more of the market than do smaller market value stocks l Large market value stocks dominate the impact on index values over time Also these series tend to be more broad than the DJIA

Unweighted Price Indicator Series All stocks carry equal weight regardless of price or market value Constructed in a parallel fashion to individuals who select stocks and invest the same dollar amount in each stock Changes in the index can be reported either in terms of arithmetic or geometric means

Style Indexes Additional indexes have been created that seek to measure the performance of various investment styles or sectors Size indexes track the performance of large -cap, mid-cap, and small cap stocks l Other indexes track the relative performance of growth and value stocks, perhaps also broken down into sizes l

Global Equity Indexes There are stock-market indexes available for most individual foreign markets l l These are closely followed within each country These are difficult to compare due to differences in sample selection, weighting, or computation In response, some standardized indexes have been developed l l l FT/S&P Actuaries World Indexes Morgan Stanley Capital International (MSCI) World Indexes Dow Jones World Stock Index

FT/S&P-Actuaries World Indexes Track over 2, 400 securities in 30 countries Covers 70% of the total value of all listed companies in each country Securities included must allow direct holdings of shares by foreign nationals Index is market-value weighted with a base date of December 31, 1986 = 100 Results are calculated daily and published the following day in the Financial Times Geographic subgroups are also published

MSCI Indexes Three international, nineteen national, and thirty-eight international industry indexes Include 1, 375 companies listed on stock exchanges in 19 countries with a combined capitalization representing 60 percent of the aggregate market value of the stock exchanges of these countries All the indexes are market-value weighted

Dow Jones World Stock Index Introduced in January 1993 Includes 28 countries with a total of 2, 200 companies worldwide, organized into 120 industry groups Countries are grouped into 3 regions Represents over 80% of the combined capitalization of these countries

Comparison of World Stock Indexes Correlations between all of the pairs of broad world indexes are nearly 1. 00, indicating that the results with the alternative world stock indexes are quite comparable

Bond-Market Indicator Series Relatively new and not widely published Growth in fixed-income mutual funds increase need for reliable benchmarks for evaluating performance Increasing interest in bond index funds, which requires an index to emulate l Many managers have not matched aggregate bond market return

Difficulties in Creating a Bond-Market Index Range of bond quality varies from U. S. Treasury securities to bonds in default Bond market changes constantly with new issues, maturities, calls, and sinking funds Bond prices are affected differently by changing interest rates dependent on maturity, coupon, and market yield Correctly pricing individual bond issues can be a challenge without current and continuous transaction prices available

Bond Market Index Series Investment-Grade Bond Indexes l l Four investment firms maintain indexes for Treasury bonds and other investment grade bonds (rated BBB or higher) Relationship among these bonds is strong (correlations average 0. 95) High-Yield Bond Indexes l l l Non investment-grade bonds (rated BB or below) Several indexes have been created Relationship among alternative high-yield indexes is weaker than among investment grade indexes

Bond Market Index Series Global Government Bond Market Indexes Global bond market dominated by government issues l Several indexes created by major investment firms l Indexes have similar characteristics l

Composite Stock-Bond Indexes Considers the benefits of diversification with asset allocation across stocks and bonds l Merrill Lynch-Wilshire U. S. Capital Markets Index (ML-WCMI) l l Market-value weighted index measures total return performance of the combined U. S. taxable fixed income and equity markets Brinson Partners Global Security Market Index (GSMI) l l Matches a typical U. S. pension fund allocation policy Close to theoretical “market portfolio of risky assets” referred to in CAPM

Comparison of Indexes Over Time Correlations among monthly equity price changes l l Most differences are attributable to sample differences High correlations between series based on NYSE firms (about. 993) Lower correlations between NYSE series and AMEX or Nasdaq series (about. 903) Correlations between U. S. series and other countries confirm the wisdom of global investing since values are much lower (averaging. 627)

Comparison of Indexes Over Time Correlations among monthly bond indexes Among investment-grade bonds correlations range from 0. 90 to 0. 99 l Low correlation in global returns to U. S. returns (. 07 to. 29) support global diversification l