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