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The Meaninglessness of the Stock Market Index in a Digital World

120 points by collapse 8y ago

tanderson92 8y ago
The Dow Jones index being a poor index (as well as being a price index) does not mean the idea of a stock market index is a poor one; the title of the article especially was poorly chosen by the editor. The S&P500 Index is another stock market index and is far from meaningless -- its level reflects expectations about the future profits of the largest 80% of American companies. The S&P500 has its own weaknesses because it does not fully capture the stock market (use something like the CRSP Total Stock Market Index or the Dow Jones U.S. Total Market Index) and because it is a price index (compare to the German DAX which is total return-based). The article overreaches in its conclusions.
- adim86 8y ago
  I think what the author is trying to point out here is that in the world we live in today the stock market indexes are less valuable. Stocks used to be able to be bought using technicals like the P/E ratio and other financial tools. As companies like facebook and snapchat and the likes. Companies whose values cannot really be calculated by the assets they hold (land, machines and factories etc). Their value is in their Brand, their IP and other subjective articles. But they are listed in the stock market and they dominate the stock market today. It generally makes these tools weaker in calculating the value of the market using stocks which was created for an industrial age
  - JumpCrisscross 8y ago
    > Companies whose values cannot really be calculated by the assets they hold Assets have value for the cash flows they promise. Facebook is a dead simple valuation exercise on a PEG basis.
  - frockington 8y ago
    Stock in Facebook is the same principle as stock in Ford. You are simply buying a share of the company. I don't see how indexing them is any less the beneficial now then it was twenty years ago
  - kgwgk 8y ago
    In March 2000, tech companies represented 35% of the S&P 500 by market cap. Cisco was briefly the largest company in the world, with a market cap similar to Facebook today (taking inflation into account its market cap was similar to Amazon today). https://www.bizjournals.com/sanjose/stories/2000/03/20/story2.html https://www.bizjournals.com/sanjose/stories/2000/03/20/story... These were the ten largest companies in the S&P 500 in January 2000: Microsoft, Cisco, Intel, IBM, AOL, Oracle, Dell, Sun, Qualcomm, and HP.
- actsasbuffoon 8y ago
  Agreed. These indices are extremely useful for trading. For just under $275, just about anyone can buy a share of SPY and make/lose money based on trends across a diverse array of the largest companies in the world. Without indices, you'd have to spend tens or hundreds of thousands of dollars for this kind of diversification. It's also useful for tracking trends within specific sectors. Think tech is undervalued? Invest in a NASDAQ ETF like QQQ or NDX. Maybe you read that OPEC is planning to increase oil production and you think that's going to devalue existing oil supplies, so you take a short position on XLE (an energy index ETF). The relative simplicity of indices means there's a lot of volume and liquidity. It's not easy to find a buyer for shares in an obscure oil company, but lots of investors would be happy to buy your energy index ETF shares. I love indices. I'd be hesitant to invest in sectors I don't know much about, like construction materials. They're heavily affected by the price of raw materials, and lately all this tariff talk has caused a lot of volatility in those prices. Which individual companies should I get involved with? It's hard to say without a fair bit of research because it's a specialized field. With an index ETF, I can quickly take a long or short position to get a little exposure to the sector without having to dig too deep.
  - abakker 8y ago
    Just a quick point of correction - be careful not to confuse an Index with an Index fund. You are talking about ETFs, which come in Index fund varieties, but the Index exists as a market indicator, not for the purpose of creating a fund. ETF providers use indices to create a very simple to maintain trading strategy and investment vehicle for low management cost, but they do not create the indexes.
    - actsasbuffoon 8y ago
      Yes, you're correct. I didn't do a good job explaining the difference. I considered editing to add a note, but I think your comment explains it clearly enough to make that unnecessary.
    - tanderson92 8y ago
      > ETF providers use indices to create a very simple to maintain trading strategy and investment vehicle for low management cost, but they do not create the indexes. It's rumored that Vanguard 'bribed' CRSP to create its Total Market index (and etc for other funds) so that its licensing fees to MSCI / Dow Jones would be lower. So while it is true they do not maintain the indices, it is possible they have a heavy role in creating the indices.
21 8y ago
All the professionals use the S&P 500 index. The Dow Jones index is used only by the popular non-financial press.
- imcoconut 8y ago
  Actually, if you could measure it globally, most institutional investors who measure/benchmark to the US stock market probably use the Russell 1000. You're point is still valid tough regarding cap weighted vs. price weighted.
- repsilat 8y ago
  The Wall Street Journal refers to the DJIA more often than the S&P 500, and they have a reasonable business section. They mostly do it because they're tied up with it, though. No great loss to them, TFA notes that they're well correlated (and gossip about GE sells papers on slow news days.)
  - bob_theslob646 8y ago
    Would be curious to see a word frequency count of both in the WSJ.
baldfat 8y ago
Seems like Warren Buffet won his bet just investing in the index (S&P 500 not Dow) over a hedge fund. "Buffett made the bet in December 2007, arguing that a fund holding the same stocks as found in the Standard & Poor's 500 index could beat the combined performance of a group of hedge funds over the following 10 years." https://www.usatoday.com/story/money/markets/2018/03/07/warren-buffett-made-10-year-bet-his-market-strategy-heres-how-he-won/402823002/ https://www.usatoday.com/story/money/markets/2018/03/07/warr...
- anoncoward111 8y ago
  That's questionable. 1998 - 2008 was a catastrophic investment period for the SAP500 (0.8x return or so). 2008 - 2018 was quite good (2-3x)
  - baldfat 8y ago
    Warren bet that the S&P 500 would out perform a managed Hedge Fund.
    - anoncoward111 8y ago
      And he would have been wrong 1998-2008, provided that the managed hedge fund literally just kept all their money in cash.
      - icebraining 8y ago
        But did hedge funds keep their money in cash? Warren's point is exactly that the funds' decisions are not worth the cost.
        xkjkls 8y ago
        It was a broad fund of hedge funds, the HFRI, if I remember correctly.
        prewett 8y ago
pembrook 8y ago
It seems like this author doesn't quite understand what they're trying to communicate here. I'm surprised this was published by the Atlantic which I generally regard as a competent media property. There's some fundamental misunderstandings of how finance works and what the DOW is vs. other indexes. For example, he doesn't seem to understand that a company's valuation (his Amazon reference) is a function of its discounted future cash flows, not present value.
- vpribish 8y ago
  The Atlantic has really dropped in quality over the last few years - while also showing up more often in the social media echo-chambers. I ignore it now
  - skybrian 8y ago
    Judging by publication name means you're missing out on some great authors. Ed Yong for science writing, for example. The best way to do it is to subscribe to authors you think are good via RSS.
- elgenie 8y ago
  The sum of discounted future cash flows is present value.
tamaharbor 8y ago
There are a lot more than 3500 publicly listed corporations.
tamaharbor 8y ago
There are a LOT more than 3500 publicly listed corporations.
- lotsofpulp 8y ago
  Bloomberg says 3600: https://www.bloomberg.com/view/articles/2018-04-09/where-have-all-the-u-s-public-companies-gone https://www.bloomberg.com/view/articles/2018-04-09/where-hav...
- xkjkls 8y ago
  That depends on if you mean securities or corporations. ETFs aren't counted as companies, and there is a hell of alot more of them than corporations.
- vpribish 8y ago
  and they are willfully ignoring the OTC market which has 10k+
ScottBurson 8y ago
There's a lot of failure to appreciate a simple fact: "1 share" is not a consistent, well-defined unit. It's just some arbitrary fraction of the value of a company, that fraction varying not only between companies but also over time, because of splits, secondary offerings, and buybacks. This seems like an obvious, straightforward fact that everybody knows, and yet historically, there has been a tendency to ignore it and to think the price of "a share" means something. Companies whose share prices are above $50 or so have been viewed as "blue chip"; those below $10 have been viewed as "speculative". There is thus a psychological component to the perception of share prices that is not justified by the mathematics of the situation; and much of this is a matter of convention. Even today, I believe that to continue to be listed on the NYSE or even NASDAQ, a company must not let its share price fall much under $1. The only effect of AMZN trading at $1730 is to make it difficult for small traders to trade the stock, since exchanges don't deal in fractional shares (they could, I suppose, but they don't). We see this error in the way that Charles Dow and Edward Jones defined their index back in 1896 [0]. Averaging prices of shares in different companies is mathematically meaningless. But the author of this piece, having commented on this error, goes on to make it again: For example, for fiscal year 2017, Costco had earnings per share of $6.08. Amazon had earnings per share of $6.15. Costco’s market value is $91 billion; Amazon’s is $844 billion. EPS numbers aren't directly comparable any more than share prices are directly comparable. COST is trading around $209, less than 1/8 AMZN. Instead of EPS, we should be talking about earnings per dollar of market cap, which would be independent of the size of a share. On that measure, COST is outperforming AMZN by a factor of more than 8. (Along with juxtaposing EPS numbers from two different companies, the author seems to be committing a second error by suggesting that earnings and market cap should be related; they are not, at least not in any simple way.)
- guntars 8y ago
  What’s the value of the company if not assets + all future earnings?
  - closeparen 8y ago
    The market clearing price.
harry8 8y ago
Once upon a time I got an undergrad degree in economics and accounting. I then later was awarded the CFA charter. Having cleared my throat with such wanton credential-ism, when kinds of articles come up I want to recommend strongly: "A Random Walk Down Wall St" by Burton Malkiel [1] Anyone wanting to have any kind of understanding of investing should have read it. Even if you already know it all from extensive study elsewhere it is important to see it all in one place, well written and explained. I say read it! Really! You have a startup and you need to understand investing in your business - this is a flying start. I can think of no better. [1] My affiliate wikipedia link https://en.wikipedia.org/wiki/A_Random_Walk_Down_Wall_Street https://en.wikipedia.org/wiki/A_Random_Walk_Down_Wall_Street
rossdavidh 8y ago
And yet, despite all the errors in the article and the title, the basic premise, that stock market indices should not be used to talk about the economy as it is experienced by anyone other than those invested in stocks, is sound. Also, old news. I learned this in 1987.
ta1234567890 8y ago
Most of the stock market is nothing but speculation. Sure, "informed" speculation, but unless you have enough ownership in a company to have some kind of power in their decision making process (or have some other advantage like insider info), then you are just guessing what the future will be.
- bob_theslob646 8y ago
  Haha, your comment actually made me laugh out loud. I would be careful with choosing your words especially when in a marketplace, there are buyers or sellers whose entire goal is to speculate . >It is controversial whether the presence of speculators increases or decreases short-term volatility in a market. Their provision of capital and information may help stabilize prices closer to their true values. On the other hand, crowd behavior and positive feedback loops in market participants may also increase volatility. [https://en.m.wikipedia.org/wiki/Speculation https://en.m.wikipedia.org/wiki/Speculation]
  - ta1234567890 8y ago
    Your comment made me scratch my head trying to figure out what you mean. Anyways, it seems you are actually confirming the statement above about speculation in the stock market. >> It is controversial... Which means, it is not proven and maybe it can't be proven, hence any assertion about the point is just speculation about which side is right or wrong

120 points by collapse 8y ago

The Dow Jones index being a poor index (as well as being a price index) does not mean the idea of a stock market index is a poor one; the title of the article especially was poorly chosen by the editor. The S&P500 Index is another stock market index and is far from meaningless -- its level reflects expectations about the future profits of the largest 80% of American companies. The S&P500 has its own weaknesses because it does not fully capture the stock market (use something like the CRSP Total Stock Market Index or the Dow Jones U.S. Total Market Index) and because it is a price index (compare to the German DAX which is total return-based). The article overreaches in its conclusions.

adim86 8y ago
I think what the author is trying to point out here is that in the world we live in today the stock market indexes are less valuable. Stocks used to be able to be bought using technicals like the P/E ratio and other financial tools. As companies like facebook and snapchat and the likes. Companies whose values cannot really be calculated by the assets they hold (land, machines and factories etc). Their value is in their Brand, their IP and other subjective articles. But they are listed in the stock market and they dominate the stock market today. It generally makes these tools weaker in calculating the value of the market using stocks which was created for an industrial age
- JumpCrisscross 8y ago
  > Companies whose values cannot really be calculated by the assets they hold Assets have value for the cash flows they promise. Facebook is a dead simple valuation exercise on a PEG basis.
- frockington 8y ago
  Stock in Facebook is the same principle as stock in Ford. You are simply buying a share of the company. I don't see how indexing them is any less the beneficial now then it was twenty years ago
- kgwgk 8y ago
  In March 2000, tech companies represented 35% of the S&P 500 by market cap. Cisco was briefly the largest company in the world, with a market cap similar to Facebook today (taking inflation into account its market cap was similar to Amazon today). https://www.bizjournals.com/sanjose/stories/2000/03/20/story2.html https://www.bizjournals.com/sanjose/stories/2000/03/20/story... These were the ten largest companies in the S&P 500 in January 2000: Microsoft, Cisco, Intel, IBM, AOL, Oracle, Dell, Sun, Qualcomm, and HP.
actsasbuffoon 8y ago
Agreed. These indices are extremely useful for trading. For just under $275, just about anyone can buy a share of SPY and make/lose money based on trends across a diverse array of the largest companies in the world. Without indices, you'd have to spend tens or hundreds of thousands of dollars for this kind of diversification. It's also useful for tracking trends within specific sectors. Think tech is undervalued? Invest in a NASDAQ ETF like QQQ or NDX. Maybe you read that OPEC is planning to increase oil production and you think that's going to devalue existing oil supplies, so you take a short position on XLE (an energy index ETF). The relative simplicity of indices means there's a lot of volume and liquidity. It's not easy to find a buyer for shares in an obscure oil company, but lots of investors would be happy to buy your energy index ETF shares. I love indices. I'd be hesitant to invest in sectors I don't know much about, like construction materials. They're heavily affected by the price of raw materials, and lately all this tariff talk has caused a lot of volatility in those prices. Which individual companies should I get involved with? It's hard to say without a fair bit of research because it's a specialized field. With an index ETF, I can quickly take a long or short position to get a little exposure to the sector without having to dig too deep.
- abakker 8y ago
  Just a quick point of correction - be careful not to confuse an Index with an Index fund. You are talking about ETFs, which come in Index fund varieties, but the Index exists as a market indicator, not for the purpose of creating a fund. ETF providers use indices to create a very simple to maintain trading strategy and investment vehicle for low management cost, but they do not create the indexes.
  - actsasbuffoon 8y ago
    Yes, you're correct. I didn't do a good job explaining the difference. I considered editing to add a note, but I think your comment explains it clearly enough to make that unnecessary.
  - tanderson92 8y ago
    > ETF providers use indices to create a very simple to maintain trading strategy and investment vehicle for low management cost, but they do not create the indexes. It's rumored that Vanguard 'bribed' CRSP to create its Total Market index (and etc for other funds) so that its licensing fees to MSCI / Dow Jones would be lower. So while it is true they do not maintain the indices, it is possible they have a heavy role in creating the indices.

21 8y ago

All the professionals use the S&P 500 index. The Dow Jones index is used only by the popular non-financial press.

imcoconut 8y ago
Actually, if you could measure it globally, most institutional investors who measure/benchmark to the US stock market probably use the Russell 1000. You're point is still valid tough regarding cap weighted vs. price weighted.
repsilat 8y ago
The Wall Street Journal refers to the DJIA more often than the S&P 500, and they have a reasonable business section. They mostly do it because they're tied up with it, though. No great loss to them, TFA notes that they're well correlated (and gossip about GE sells papers on slow news days.)
- bob_theslob646 8y ago
  Would be curious to see a word frequency count of both in the WSJ.

baldfat 8y ago

Seems like Warren Buffet won his bet just investing in the index (S&P 500 not Dow) over a hedge fund. "Buffett made the bet in December 2007, arguing that a fund holding the same stocks as found in the Standard & Poor's 500 index could beat the combined performance of a group of hedge funds over the following 10 years." https://www.usatoday.com/story/money/markets/2018/03/07/warren-buffett-made-10-year-bet-his-market-strategy-heres-how-he-won/402823002/ https://www.usatoday.com/story/money/markets/2018/03/07/warr...

anoncoward111 8y ago
That's questionable. 1998 - 2008 was a catastrophic investment period for the SAP500 (0.8x return or so). 2008 - 2018 was quite good (2-3x)
- baldfat 8y ago
  Warren bet that the S&P 500 would out perform a managed Hedge Fund.
  - anoncoward111 8y ago
    And he would have been wrong 1998-2008, provided that the managed hedge fund literally just kept all their money in cash.
    - icebraining 8y ago
      But did hedge funds keep their money in cash? Warren's point is exactly that the funds' decisions are not worth the cost.
      - xkjkls 8y ago
        It was a broad fund of hedge funds, the HFRI, if I remember correctly.
      - prewett 8y ago

pembrook 8y ago

It seems like this author doesn't quite understand what they're trying to communicate here. I'm surprised this was published by the Atlantic which I generally regard as a competent media property. There's some fundamental misunderstandings of how finance works and what the DOW is vs. other indexes. For example, he doesn't seem to understand that a company's valuation (his Amazon reference) is a function of its discounted future cash flows, not present value.

vpribish 8y ago
The Atlantic has really dropped in quality over the last few years - while also showing up more often in the social media echo-chambers. I ignore it now
- skybrian 8y ago
  Judging by publication name means you're missing out on some great authors. Ed Yong for science writing, for example. The best way to do it is to subscribe to authors you think are good via RSS.
elgenie 8y ago
The sum of discounted future cash flows is present value.

tamaharbor 8y ago

There are a lot more than 3500 publicly listed corporations.

tamaharbor 8y ago

There are a LOT more than 3500 publicly listed corporations.

lotsofpulp 8y ago
Bloomberg says 3600: https://www.bloomberg.com/view/articles/2018-04-09/where-have-all-the-u-s-public-companies-gone https://www.bloomberg.com/view/articles/2018-04-09/where-hav...
xkjkls 8y ago
That depends on if you mean securities or corporations. ETFs aren't counted as companies, and there is a hell of alot more of them than corporations.
vpribish 8y ago
and they are willfully ignoring the OTC market which has 10k+

ScottBurson 8y ago

There's a lot of failure to appreciate a simple fact: "1 share" is not a consistent, well-defined unit. It's just some arbitrary fraction of the value of a company, that fraction varying not only between companies but also over time, because of splits, secondary offerings, and buybacks. This seems like an obvious, straightforward fact that everybody knows, and yet historically, there has been a tendency to ignore it and to think the price of "a share" means something. Companies whose share prices are above $50 or so have been viewed as "blue chip"; those below $10 have been viewed as "speculative". There is thus a psychological component to the perception of share prices that is not justified by the mathematics of the situation; and much of this is a matter of convention. Even today, I believe that to continue to be listed on the NYSE or even NASDAQ, a company must not let its share price fall much under $1. The only effect of AMZN trading at $1730 is to make it difficult for small traders to trade the stock, since exchanges don't deal in fractional shares (they could, I suppose, but they don't). We see this error in the way that Charles Dow and Edward Jones defined their index back in 1896 [0]. Averaging prices of shares in different companies is mathematically meaningless. But the author of this piece, having commented on this error, goes on to make it again: For example, for fiscal year 2017, Costco had earnings per share of $6.08. Amazon had earnings per share of $6.15. Costco’s market value is $91 billion; Amazon’s is $844 billion. EPS numbers aren't directly comparable any more than share prices are directly comparable. COST is trading around $209, less than 1/8 AMZN. Instead of EPS, we should be talking about earnings per dollar of market cap, which would be independent of the size of a share. On that measure, COST is outperforming AMZN by a factor of more than 8. (Along with juxtaposing EPS numbers from two different companies, the author seems to be committing a second error by suggesting that earnings and market cap should be related; they are not, at least not in any simple way.)

guntars 8y ago
What’s the value of the company if not assets + all future earnings?
- closeparen 8y ago
  The market clearing price.

harry8 8y ago

Once upon a time I got an undergrad degree in economics and accounting. I then later was awarded the CFA charter. Having cleared my throat with such wanton credential-ism, when kinds of articles come up I want to recommend strongly: "A Random Walk Down Wall St" by Burton Malkiel [1] Anyone wanting to have any kind of understanding of investing should have read it. Even if you already know it all from extensive study elsewhere it is important to see it all in one place, well written and explained. I say read it! Really! You have a startup and you need to understand investing in your business - this is a flying start. I can think of no better. [1] My affiliate wikipedia link https://en.wikipedia.org/wiki/A_Random_Walk_Down_Wall_Street https://en.wikipedia.org/wiki/A_Random_Walk_Down_Wall_Street

rossdavidh 8y ago

And yet, despite all the errors in the article and the title, the basic premise, that stock market indices should not be used to talk about the economy as it is experienced by anyone other than those invested in stocks, is sound. Also, old news. I learned this in 1987.

ta1234567890 8y ago

Most of the stock market is nothing but speculation. Sure, "informed" speculation, but unless you have enough ownership in a company to have some kind of power in their decision making process (or have some other advantage like insider info), then you are just guessing what the future will be.

bob_theslob646 8y ago
Haha, your comment actually made me laugh out loud. I would be careful with choosing your words especially when in a marketplace, there are buyers or sellers whose entire goal is to speculate . >It is controversial whether the presence of speculators increases or decreases short-term volatility in a market. Their provision of capital and information may help stabilize prices closer to their true values. On the other hand, crowd behavior and positive feedback loops in market participants may also increase volatility. [https://en.m.wikipedia.org/wiki/Speculation https://en.m.wikipedia.org/wiki/Speculation]
- ta1234567890 8y ago
  Your comment made me scratch my head trying to figure out what you mean. Anyways, it seems you are actually confirming the statement above about speculation in the stock market. >> It is controversial... Which means, it is not proven and maybe it can't be proven, hence any assertion about the point is just speculation about which side is right or wrong