John,
Yet another excellent Barrons piece suggests further refinement of the model -- replacing the SP500 index with an index more representative of the portfolios of the people who are polled in the surveys -- perhaps the Value Line Index (which is non-market cap weighted but equal dollar amounts of largest 1600 stocks), or, in my opinion, an even more volatile smaller cap index (any suggestions?).
At any rate, here's a significant part of the article:
" In struggling to explain the stock market's wild gyrations, commentators
have taken to slicing and dicing some of the most commonly used indexes. For
example, when the market was roaring a few months back, it wasn't uncommon to
read an analysis that read something like, ``Yeah, sure, the Standard & Poor's 500
Index was up 23% in 1996, but nearly three-quarters of that rise was due to the
100 largest companies.'' And now, with the market having slid precipitously, the
large-caps have fallen the most, so watch for commentary that attributes much of
the decline to giant highflyers like Intel and Microsoft.
What good are indexes if one has to constantly remove major parts of them to get a
clear picture of what's happening with the overall market?
The problem, of course, is that an index like the S&P gives greater clout to the
movement of its most valuable companies. The top 50 issues in the index actually
account for a whopping 47.6% of its total value.
Of course you can make a good case that the movement of the largest company in
the index - General Electric, with a market capitalization of $161 billion - should
receive greater weight than its smallest company - Intergraph Corp., with a
market cap of $368 million. But the mania for investing in S&P index funds has
created undue buying enthusiasm for the nation's largest, most valuable stocks. As
Barron's has noted, the result is that the S&P Index begins to resemble a
perpetual-motion machine. And we all know that such machines never prove as
perpetual as their inventors would have us believe.
All the more reason that we not twist ourselves into pretzels to judge the market
strictly by using the S&P 500 Index, or other capitalization-weighted measures. To
the rescue comes the little-known Value Line Arithmetic Index, which is published
in the Market Laboratory section of Barron's each week. This hardy barometer
measures the percentage gains and losses for 1,600 of the nation's largest stocks,
including those in the S&P 500. It's essentially like tracking a portfolio consisting of
equal dollar amounts of these 1,600 stocks. In other words, there are no
capitalization-weighted biases.
The Value Line Index has
lagged the Standard & Poor's
500 since turn-of-the-year '95.
But the VLI has fallen by less
in the recent market break.
As you can see from the
accompanying chart, the
Value Line Index and the
S&P 500 tell somewhat
different stories about
what's been happening in
the stock market since the
beginning of last year. While both portray an impressive bull run, the Value Line
version charts a rise that's been noticeably more restrained - and a recent pullback
that's been markedly less severe.
Put simply, the Value Line Index didn't get carried away with undue enthusiasm for
the market's biggest players, nor did it get slammed so hard after the market broke.
Early this year, while the S&P jumped by 10.7%, the Value Line Index rose by a
more reasonable 7%.
Though the high on the VLI wasn't as great as the S&P's, neither was the hangover.
As of Thursday, the S&P had thudded nearly 9% from its high, while the VLI had
declined by about 7%.
The Value Line Index is the quintessential ``little-guy'' yardstick. Unlike the
manager of an index fund, an investor who trades for his own account has no
special stake in allocating his investable funds according to capitalization-weighting.
Thus, if he happens to like three stocks, one a small-cap, the second a mid-cap and
the third a large-cap, he might do what in today's brave new world of market
indexing would be thought of as strange: He might put an equal number of dollars
into each issue.
He'll make that kind of allocation decision for a couple of old-fashioned reasons.
First, after risk and reward are taken into account, he'll have no special need to
favor a large stock over a smaller one. Second, even if his stake exceeds $1
million, he'll have no fear of buying up so much of any particular company that his
purchase might goose the price.
If this investor wants an index to
measure his performance against, he
shouldn't choose any of the popular
capitalization-weighted indexes like
the S&P 500. He'd be better off
measuring himself against the Value
Line Index.
It's worth noting that the Value Line
Index is the basis of a futures contract traded, however thinly, on the Kansas City
Board of Trade as well as an options contract listed on the Philadelphia Stock
Exchange." |
