Chapter 7 SECURITY-MARKET INDICATOR SERIES
Dec 23, 2015
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 performanceFor development of an index portfolioFor examining factors that influence aggregate security price movementsFor technical analysis, to predict future price movementsTo 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 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 Should the weighting system be based on price,
total firm value, or equally weighted?
Computational procedure How should the values of the index be reported
and tracked (arithmetic or geometric mean)?
Stock-Market Indicator Series
Price-Weighted Series Dow Jones Industrial Average (DJIA)
Value-Weighted Series NYSE Composite S&P 500 Index Russell Indexes Willshire 5000 Index
Equal-Weighted Series Value Line Averages
Dow Jones Industrial Average (DJIA)
Best-known, oldest, most popular indexPrice-weighted average of thirty large well-known industrial stocks, leaders in their industry, and listed on NYSETotal the current price of the 30 stocks and divide by a divisor 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 30 non-randomly selected blue-chip stocks are not
representative of the 1800 NYSE listed stocks
Price-weighted series 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 seriesMarket Value = Number of Shares Outstanding x Current Market Price
Beginning index value is usually 100, new market values change the value of the indexAutomatic adjustment for splitsWeighting 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
ValueIndex BeginningIndex t
bb
tt
QP
QP
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 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 valueConstructed in a parallel fashion to individuals who select stocks and invest the same dollar amount in each stockChanges 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 sectorsSize indexes track the performance of
large-cap, mid-cap, and small cap stocksOther indexes track the relative
performance of growth and value stocks, perhaps also broken down into sizes
Global Equity Indexes
There are stock-market indexes available for most individual foreign markets 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 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 countriesCovers 70% of the total value of all listed companies in each countrySecurities included must allow direct holdings of shares by foreign nationalsIndex is market-value weighted with a base date of December 31, 1986 = 100Results are calculated daily and published the following day in the Financial TimesGeographic 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 publishedGrowth in fixed-income mutual funds increase need for reliable benchmarks for evaluating performanceIncreasing interest in bond index funds, which requires an index to emulateMany 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 defaultBond market changes constantly with new issues, maturities, calls, and sinking fundsBond prices are affected differently by changing interest rates dependent on maturity, coupon, and market yieldCorrectly pricing individual bond issues can be a challenge without current and continuous transaction prices available
Bond Market Index Series
Investment-Grade Bond Indexes 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 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 IndexesGlobal bond market dominated by
government issuesSeveral indexes created by major
investment firms Indexes have similar characteristics
Composite Stock-Bond Indexes
Considers the benefits of diversification with asset allocation across stocks and bonds Merrill Lynch-Wilshire U.S. Capital Markets Index
(ML-WCMI) 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)
Matches a typical U.S. pension fund allocation policy Close to the theoretical “market portfolio of risky assets”
referred to in CAPM
Comparison of Indexes Over Time
Correlations among monthly equity price changes 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 indexesAmong investment-grade bonds
correlations range from 0.90 to 0.99Low correlation in global returns to U.S.
returns (.07 to .29) support global diversification