Financial Market Analysis

Investment

Management UNIT 4 – MARKET INDICES

Source Material

 Reilly, F. K. & Brown, K.C. (2003). Investment Analysis, Portfolio

Management. 7th Ed. South Western Publishing

Market Indices

 If an investor owns more than a few stocks or bonds, it is cumbersome to

follow each stock or bond individually to determine the composite

performance of the portfolio.

 Also, there is an intuitive notion that most individual stocks or bonds move

with the aggregate market.

 Therefore, if the ov erall market rose, an individual’s portfolio probably also increased in v alue.

 Indexes are useful in assessing investment results.

 They provide a benchmark against which performance can be compared.

 They are also useful in financial research, through which an investigator seeks to discover the relationship between certain economic v ariables and market results.

Uses of Security Market Indexes

A benchmark to evaluate the performance of professional money managers

 A primary application is to use the index values to compute total returns and risk for an aggregate market or some component of a market, over a specified time period,

 and use the rates of return and risk measures computed as a benchmark to judge the performance of individual portfolios.

 A basic assumption when evaluating portfolio performance is that any investor should be able to experience a risk-adjusted rate of return comparable to the market

 by randomly selecting a large number of stocks or bonds from the total market;

 Hence, a superior portfolio manager should consistently do better than the market.

 Therefore, an aggregate stock or bond market index can be used as a benchmark to judge the performance of professional money managers.

Uses of Security Market Indexes

To Create and Monitor an Index Funds:

 Indicator series are also used to develop an index portfolio.

 It is difficult for most money managers to consistently outperform specified

market indexes on a risk adjusted basis over time.

 If this is true, an obvious alternative is to invest in a portfolio that will emulate the market portfolio.

 This notion led to the creation of index funds, whose purpose is to track the performance of the specified market series (index) over time.

 The original index fund concept was related to common stocks.

 Subsequently, development of comprehensive well specified bond

market indexes and similar inferior performance relative to the bond

market by most bond portfolio managers have led to a similar

phenomenon in the fixed-income area (bond index funds).

Uses of Security Market Indexes

To measure market rates of return in economic

studies:

Securities analysts, portfolio managers, and

others use security market indexes to examine

the factors that influence aggregate security

price movements

T hat is, the indexes are used to measure aggregate market movements.

Uses of Security Market Indexes

For predicting future market movements by technicians:

 Another group interested in an aggregate market series is

“technicians,” who believe past price changes can be used

to predict future price movements.

 For example, to project future stock price movements,

technicians would plot and analyze price and volume

changes for a stock market series like the Dow Jones Industrial

Average.

Uses of Security Market Indexes

As a proxy for the market portfolio of risky assets when

calculating the systematic risk of an asset

 Works in portfolio and capital market theory have

implied that the relevant risk for any individual risky asset

is its systematic risk

 which is the relationship between the rates of return for a risky asset and the rates of return for a market portfolio of risky assets.

 Therefore, in this case, an aggregate market index is

used as a proxy for the market portfolio of risky assets.

Differentiating factors in Constructing Market Indices

 Because the indicator series are intended to reflect the

overall movements of a group of securities, it is necessary to

consider which factors are important when constructing an

index that is intended to represent a total population.

 The following factors are important:

 The Sample

 Weighting Sample Members

 Computational Procedure

Differentiating factors in Constructing Market Indices Sample

The size of the sample, the breadth of the sample, and the source of the sample used to construct a series are all important.

 A small percentage of the total population will provide valid indications of the behavior of the total population if the sample is properly selected.

 In fact, at some point the costs of taking a larger sample will almost certainly outweigh any benefits of increased size.

 The sample should be representative of the total population; otherwise, its size will be meaningless.

 A large biased sample is no better than a small biased sample.

 The sample can be generated by completely random selection or by a non-random selection technique that is designed to incorporate the characteristic of the desired population.

 Finally, the source of the sample is important.

 If there are any differences between segments of the population, in which case samples from each segment are required.

Differentiating factors in Constructing Market Indices

Weighting sample members

 This concern is with the weight given to each member in the

sample.

 Three principal weighting schemes are used:

 A price-weighted series

 A market-value-weighted series

 An un-weighted series, or what would be described as an

equally weighted series.

Differentiating factors in Constructing Market Indices

Computational Procedures

 The final consideration is selecting the computational procedure.

 One alternative is to take a simple arithmetic average of the various members in the series.

 Another is to compute an index and have all changes, whether in price or value, reported in terms of the basic index.

 Finally, some prefer using a geometric average of the components rather than an arithmetic average.

Stock Market Indicator Series

Price Weighted Series

 A price-weighted series is an arithmetic average of current prices, which means that index movements are influenced by the differential prices of the components.

The Dow Jones Industrial Average (DJIA)

 This is the best-known price-weighted series and also the oldest and certainly the most popular stock market indicator series. The DJIA is a price-weighted average of 30 large, well-known industrial stocks that are generally the leaders in their industry (blue chips). It has been a widely followed indicator of the stock market since October 1, 1928.

 The DJIA is computed by totaling the current prices of the 30 stocks and dividing the sum by a divisor that has been adjusted to take account of stock splits and changes in the sample over time.

 The divisor is adjusted so that the index v alue will be the same before and after the split.

Example of Change in DJIA Divisor When a Sample Stock Splits

After Three-for One

Before Split Split by Stock A

Prices Prices

A 30 10

B 20 20

C 10 10

60 3 = 20 40 X = 20

X = 2 (New Divisor)

 

Stock Market Indicator Series

30

DJIAt = Σ pit/ Dadj i=1

Where

DJIAt = the value of the DJIA on day t

pit = the closing price of stock i on day t

Dadj = the adjusted divisor on day t

Stock Market Indicator Series

For Example

PERIOD T+ 1 .

Period T Case A Case B

A 100 110 100

B 50 50 50

C 30 30 33

Sum 180 190 183

Divisor 3 3 3

Average 60 63.3 61

Percentage Change 5.5% 1.7%

Criticisms of the Dow Jones Industrial Average (DJIA)

 Limited to 30 non-randomly selected blue-chip stocks that cannot be

representative of the thousands of U.S. stocks.

 Includes mostly large, mature, blue-chip companies rather than the typical company.

 Several studies have shown that the DJIA has not been as volatile as other

market indexes and its long-run returns are not comparable to other NYSE stock indexes.

 The divisor needs to be adjusted every time one of the companies in the index

has a stock split.

 Because the DJIA is price weighted, when companies have a stock split, their prices

decline, and therefore their weight in the DJIA is reduced—even though they may be large and important. Therefore, the weighting scheme causes a downward bias in the

DJIA, because high-growth stocks will have higher prices; and, because such stocks tend to split, they will consistently lose weight within the index.

Nikkei-Dow Jones Average

 Also referred to as the Nikkei Stock Average Index, the Nikkei–

Dow Jones Average is an arithmetic average of prices for 225

stocks on the First Section of the Tokyo Stock Exchange (TSE).

 This best-known series in Japan, shows stock price trends since

the reopening of the TSE.

 Notably, it was formulated by Dow Jones and Company, and,

similar to the DJIA, it is a price-weighted series.

 It is also criticized because the 225 stocks that are included

comprise only about 15 percent of all stocks on the First Section.

 It is reported daily in The Wall Street Journal and the Financial

Times and weekly in Barron’s.

Market Value Weighted Series

 A market-value-weighted series is generated by deriving the initial

total market value of all stocks used in the series.

Market Value = Number of Shares Outstanding × Current

Market Price

 This initial figure is typically established as the base and assigned an

index value (the most popular beginning index value is 100, but it

can vary—say, 10, 50).

 Subsequently a new market value is computed for all securities in

the index, and the current market value is compared to the initial

“base” value to determine the percentage of change, which in turn

is applied to the beginning index value.

Market Value Weighted Series

Index t = ΣPt Qt

ΣPbQb

Where:

 Index t = 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

X Beginning Index Value

Market Value Weighted Series STOCK SHARE PRICE NUMBER OF SHARES MARKET VALUE

31-Dec-18

A $10.00 1,000,000 $10,000,000.00

B $15.00 6,000,000 $90,000,000.00

C $20.00 5,000,000 $100,000,000.00

TOTAL $200,000,000.00

31-Dec-19

A $12.00 1,000,000 $12,000,000.00

B $10.00 12,000,000 (a) $120,000,000.00

C $20.00 5,500,000 (b) $110,000,000.00

TOTAL $242,000,000.00

Base Value Equal to an Index of 100

(a) Stock split two-for-one during the year.

(b) Company paid a 10 percent stock dividend during the year.

Market Value Weighted Series

New Index = Current Market Value

Base Value

= 242,000,000

200,000,000

= 1.21 X 100

New Index = 121

% Change in index = [(121-100)/100] x 100 = 21%

 There is an automatic adjustment for stock splits and other capital changes with a

value-weighted index because the decrease in the stock price is offset by an

increase in the number of shares outstanding.

 The importance of individual stocks in the sample depends on the market value of

the stocks. Therefore, a specified percentage change in the value of a large

company has a greater impact than a comparable percentage change for a small

company.

X Beginning Index Value

X 100

Market Value Weighted Series

Examples of value weighted series

 Standard and Poor's Indexes

 New York Stock Exchange Index

 NASDAQ Series

 American Stock Exchange Market Value Index

 Wilshire 5000 Equity Index

 Russell Indexes

 Financial Times Actuaries Indexes

 Tokyo Stock Exchange Price Index

 FT-Actuaries World Indexes

 Morgan Stanley Capital International Indexes

 Dow Jones World Stock Index

 Euro-money-First Boston Global Stock Index

 Salomon-Russell World Equity Index

Unweighted Price Indicator Series

 In an un-weighted index, all stocks carry equal weight

regardless of their price or market value.

 A $20 stock is as important as a $40 stock, and the total market value of the company is unimportant.

 Such an index can be used by individuals who randomly select stock for their portfolio and invest the same dollar amount in each stock.

 One way to visualize an un-weighted series is to assume that

equal dollar amounts are invested in each stock in the portfolio

at the beginning of the period.

 For example, an equal $1,000 investment in each stock would work out to 50 shares of a $20 stock, 100 shares of a $10 stock, and 10 shares of a $100 stock.

Unweighted Price Indicator Series

 In fact, the actual movements in the index are typically

based on the arithmetic average of the percent changes in

price or value for the stocks in the index.

 The use of percentage price changes means that the

price level or the market value of the stock does not make

a difference - each percentage change has equal

weight.

 This arithmetic average of percent changes procedure is

used in academic studies when the authors specify equal

weighting.

 Examples of un-weighted series include Value Line Averages

and Financial Times Ordinary Share Index.

Unweighted Price Indicator Series

 In contrast to computing an arithmetic average of percentage changes,

both Value Line and the Financial Times Ordinary Share Index compute a

geometric mean of the holding period returns (HPR) and derive the holding

period yield (HPY)

EXAMPLE OF AN ARITHMETIC AND GEOMETRIC MEAN OF PERCENTAGE CHANGES

STOCK T T + 1 HPR HPY

X $10.00 $12.00 1.2 0.2

Y $22.00 $20.00 0.91 -0.09

Z $44.00 $47.00 1.07 0.07

II = 1.20 × 0.91 × 1.07 Σ =0.18

II = 1.168 0.18/3 = 0.06

1.1681/3 = 1.0531 6%

Index Value (T) × 1.0531 = Index Value (T + 1)

Index Value (T) × 1.06 = Index Value (T + 1)

SHARE PRICE

Global Equity Index

 While local indexes are closely followed within each country, a problem

arises in comparing the results implied by these indexes across countries

because of a lack of consistency among them in terms of sample

selection, weighting, or computational procedure.

 To solve these comparability issues, several groups have computed a set

of consistent country stock indexes. As a result, these indexes can be

directly compared and can be combined to create various regional

indexes. Such indexes include:

 Financial Times/S&P-Actuaries World Indexes

 Morgan Stanley Capital International (MSCI) Index

 Dow Jones World Stock Index:

FT/S&P-Actuaries World Indexes

 The FT/S&P-Actuaries World Indexes are jointly compiled by the Financial

Times Limited, Goldman Sachs and Company, and Standard and Poor’s

(the “compilers”) in conjunction with the Institute of Actuaries and the

Faculty of Actuaries.

 Approximately 2,271 equity securities in 30 countries are measured,

covering at least 70 percent of the total value of all listed companies in

each country.

 All securities included must allow direct holdings of shares by foreign nationals.

 The indexes are market-value weighted and have a base date of

December 31, 1986 = 100.

 The index results are reported in U.S. dollars, U.K. pound sterling, Japanese

yen, German marks, and the local currency of the country. In addition to

the individual countries and the world index, there are several geographic

subgroups,

Morgan Stanley Capital International (MSCI) Indexes

 The MSCI Indexes consist of 3 international, 19 national, and 38 international industry indexes. The indexes consider some 1,375 companies listed on stock exchanges in 19 countries with a combined market capitalization that represents approximately 60 percent of the aggregate market value of the stock exchanges of these countries. All the indexes are market-value weighted.

 In addition to reporting the indexes in U.S. dollars and the country’s local currency, the following valuation information is available: (1) price-to-book value (P/BV) ratio, (2) price-to-cash earnings (earnings plus depreciation) (P/CE) ratio, (3) price-to- earnings (P/E) ratio, and (4) dividend yield (YLD). These ratios help in analyzing different valuation levels among countries and over time for specific countries.

 Notably, the Morgan Stanley group index for Europe, Australia, and the Far East (EAFE) is being used as the basis for futures and options contracts on the Chicago Mercantile Exchange and the Chicago Board Options Exchange. Several of the MSCI country indexes, the EAFE index, and a world index are reported daily in The Wall Street Journal.

Dow Jones World Stock Index

 In January 1993, Dow Jones introduced its World Stock Index with results beginning December 31, 1991.

 Composed of more than 2,200 companies worldwide and organized into 120 industry groups, the index includes 33 countries representing more than 80 percent of the combined capitalization of these countries.

 Each country’s index is calculated in its own currency as well as in U.S. dollar.

 The countries are grouped into three major regions:

 Asia/Pacific

 Europe/Africa

 The Americas

Bond Market Indicator Series

 The creation and computation of bond market indexes is more difficult than

a stock market series for several reasons.

 First, the universe of bonds is much broader than that of stocks, ranging

from U.S. Treasury securities to bonds in default.

 Second, the universe of bonds is changing constantly because of new

issues, bond maturities, calls, and bond sinking funds.

 Third, the volatility of prices for individual bonds and bond portfolios

changes because bond price volatility is affected by duration, which is

likewise changing constantly because of changes in maturity, coupon,

and market yield

 Finally, significant problems can arise in correctly pricing the individual

bond issues in an index (especially corporate and mortgage bonds)

compared to the current and continuous transactions prices available

for most stocks used in stock indexes.

Bond Market Indicator Series

Investment-Grade Bond Indexes

 Four investment firms have created and maintained indexes for Treasury bonds

and other bonds considered investment grade; that is, the bonds are rated BBB

or higher. The firms were;

 Lehman Brothers

 Merrill Lynch

 Ryan Treasury

 Salomon Smith Barney

 The relationship among the returns for these investment-grade bonds is strong

(that is, the correlations among the returns average about 0.95), regardless of

the segment of the market.

 Returns for all these bonds are driven by aggregate interest rates - shifts in the gov ernment yield curve.

Bond Market Indicator Series

High-Yield Bond Indexes

 One of the fastest-growing segments of the U.S. bond market during the

past 15 years has been the high-yield bond market, which includes bonds

that are not investment grade—that is, they are rated BB, B, CCC, CC, and

C. Because of this growth, four investment firms created indexes related to

this market.

 The relationship among the alternative high-yield bond indexes is weaker

than among the investment-grade indexes, and this is especially true for

the bonds rated CCC. The associated firms are:

 C.S First Boston

 Lehman Brothers

 Merrill Lynch

 Salomon Smith Barney

Bond Market Indicator Series

Merrill Lynch Convertible Securities Indexes

 In March 1988, Merrill Lynch introduced a convertible bond index with

data beginning in January 1987.

 This index includes 600 issues in three major subgroups: U.S. domestic

convertible bonds, Eurodollar convertible bonds issued by U.S.

corporations, and U.S. domestic convertible preferred stocks.

 The issues included must be public U.S. corporate issues, have a

minimum par value of $25 million, and have a minimum maturity of

one year.

Bond Market Indicator Series

Global Government Bond Indexes

 Similar to the high-yield bond market, the global bond market

has experienced significant growth in size and importance

during the recent 10-year period.

 Unlike the high-yield bond market, this global segment is

completely dominated by government bonds because few

non-U.S. countries have a corporate bond market.

 An analysis of performance in this market indicates that the

differences (total sample sizes and the number of countries

included) have caused some large differences in the long-term

risk-return performance by the alternative indexes.