June 2018 Comments: Stock Indexes

Victor Levinson Comments

During the month of June, it was announced that General Electric’s stock would be dropped from the Dow Jones Industrial Average (DJIA) of 30 large company stocks. For those of us who remember GE as the largest company by market value in the stock market, this was shocking news.  The stock that people had been told never to sell had fallen so far in value that it no longer warranted being included in the DJIA. But what is the real significance of this event in 2018?

To answer this question, we thought it would be helpful to review the subject of investment indexes, since Park Piedmont Advisors (PPA) uses index funds for most of our client portfolio investments.

The stock market has many indexes that can be invested in using exchange traded funds (ETFs) or mutual funds, and we will discuss the main indexes below. The most popularly cited index in the financial media is the aforementioned DJIA. Started in 1896 with twelve stocks (the only stock that remained in the index from back then was GE), it has grown to include thirty large company, US-based stocks.  The ten largest stocks (measured by market value, defined below) in the DJIA  (as of June 26-27, 2018) are Apple; Microsoft; Johnson & Johnson; JPMorgan Chase; Exxon-Mobil; Chevron; Walmart; Intel; Visa; and United Healthcare.

The DJIA calculates its daily value by taking the sum of the price per share of all constituent companies, then adjusting with a factor that accounts for stock splits and stock dividends. Daily changes in the index are impacted most by the price of certain high-priced stocks. The stocks with the biggest impact on the value of DJIA are the highest-priced stocks. The current top ten are Boeing; Goldman Sachs; United Healthcare; Home Depot; 3M; Apple; McDonalds; IBM; Caterpillar; and Visa. Note that eight of the ten highest-priced stocks are not among the highest in market value.

This focus on price explains why GE was dropped from the index, since its price went as low as $12.61 during the past twelve months (see NYT, 6/19/18, page B2). Notwithstanding this odd methodology in measuring its value, and the fact it only contains 30 stocks, the DJIA is a popular and highly referenced measure of the price changes of the overall US stock market.

In contrast to the DJIA is the S&P 500 index, which contains approximately 500 stocks, making it far more diversified. The S&P 500 uses market value to weight the daily changes to its value. Market value is derived by taking the price per share (constantly changing in the financial markets, and easily obtainable) and multiplying by the number of shares outstanding of the company. The ten largest stocks in the S&P 500 index are Apple; Microsoft; Amazon; Facebook; Berkshire Hathaway; Johnson & Johnson; JP Morgan Chase; Exxon Mobil; Alphabet (Google) A and C.  So, five of the ten largest stocks by market value in the S&P 500 are not included in the DJIA. Apple, as the largest stock in the S&P 500, valued at $900 billion, represents only 4% of the overall value of the index (which comes to approximately $23 trillion at current values). The top ten stocks represent approximately 20% of the value of the index. GE is still large enough by value to remain #40 in the S&P 500, but is only 0.5% of the index value, making it no longer a meaningful component.

The other major US index is the NASDAQ Composite, which is very popular these days because of its emphasis on technology stocks. The top nine stocks by market value are technology-related (counting Alphabet/Google as two), namely Apple; Amazon; Alphabet A and C; Microsoft; Facebook; Intel; Cisco; and Netflix. The total current market value of these stocks is $4.3 trillion, or approximately 40% of the current total index value of $11.6 trillion.

There are also investable indexes for the Total US Stock Market, which tracks between 3,000 and 5,000 large, medium and small cap stocks, contained in all the indices mentioned above, and which represents all US stocks, with a current total value of approximately $30 trillion. One of the funds based on this index (the Vanguard Total Stock Market Admiral Index fund, symbol VTSAX) is a core investment for PPA and its clients.

Other core index investments used by PPA include Developed International (Vanguard fund symbol VTMGX) and Emerging Market International (Vanguard fund symbol VEMAX). VTMGX tracks approximately 3,800 stocks of companies in Europe (52%); certain Pacific region countries, dominated by Japan (38%); and Canada (8%). The ten largest stocks represent 10% of the index, including Royal Dutch (two classes); Nestle; Samsung; HSBC Bank; Toyota; Novartis; BP Petroleum, and Total Petroleum.

Interestingly, Chinese companies are still categorized as emerging market, so the VEMAX fund is dominated by China (20% of value is in Chinese companies, followed by Taiwan with 12% and India with 7%). VEMAX tracks approximately 4,000 stocks, and the largest ten represent approximately 18% of the index, including Tencent; Alibaba; Taiwan Semiconductor; Naspers; China Construction Bank; Taiwan Semiconductor Manufacturing; Industrial and Commercial Bank of China; Badu; and China Mobil.

There are also hundreds of sector index ETFs and mutual funds, allowing investors/traders to focus on specific parts of the overall stock market. In PPA-managed portfolios, we sometimes use a biotechnology stock index fund (symbol IBB) and a real estate investment trust, or REIT, stock index fund (symbol VGSLX), as these sectors are underrepresented in the broad index funds we use as core investments.  Bond funds can also be established and managed as index funds, although many large, diversified bond funds are not strictly speaking index funds.

While the end-of-June numerical value of the DJIA is approximately 24,000, the S&P 500 2,700, and the NASDAQ Composite 7,500, these figures have no bearing on the underlying value of the stocks in the indexes.  Rather, they represent the current figures of all the historical calculations that have been made to arrive at daily changes in value. Most media tend to focus on numerical changes to the indices’ values.

However, rather than focusing on the numerical value, the focus should be on the percentage change in the indexes over whatever period of time is being measured. For example, a 27-point change in the S&P 500 is 1%, while a 200-point change on the DJI is about 0.75%, and a 50-point change in the NADADQ is 0.67%. Note also that all the charts on the last two pages of each Monthly Comments use these three indexes to represent changes in the stock market.

With all this as background, a question arises: why not just invest in the high flying NASDAQ index? The answer comes back to the story of GE. No company or group of companies stays on top forever, even though at the time of their ascendancy it appears that way. The so called “Nifty Fifty” of the 1970s, starring Xerox and Polaroid, and the bankruptcy of General Motors, along with the example of GE, tells us that at some point even the most valuable companies can see their earnings slow down, competitors outperform, or regulatory issues impede growth, in addition to other concerns that may cause the stock price to decline.

At PPA, we prefer investing in the broadest and most diversified indexes, with a few sectors sprinkled in, to avoid the serious declines that can accompany a fall from favor of a few high flyers. In doing so, PPA accepts that it will not outperform the market by emphasizing the current high flyers, but rather should earn the returns provided by the broad-based, market-tracking index funds we use on behalf of our clients.