How is the Market Doing?
Despite all the noise being trumpeted by the media, the daily prattle about market moves is often wide of the mark and overloaded with information that is misleading or just plain inaccurate. How else to explain a jump of several hundred points one day followed by a plunge the next day? That makes no sense.
Over time, the foundation for stock valuations is underlying profitability of the companies involved. As profits increase, stock prices rise, though not necessarily in perfect reflection. The relationship tends to be meaningful over extended periods, but often not in shorter spans of time. That’s all about changes in investor psychology.
So let’s begin by defining the “market”. If we are referring to stocks, the most common reference is to the Dow Jones Industrial Average, which consists of 30 major companies whose progress might be considered representative of the U.S. economy as a whole. The majority of the companies included here are relatively mature, growing at a more moderate pace. But limiting the view to such a small group of giant companies essentially ignores what’s taking place with thousands of other domestic companies. And let’s not forget that a substantial portion of the revenues these companies generate comes from non-U.S. activities.
The Standard & Poor’s 500 takes a broader view that is the benchmark for investment professionals. The significant flaw with the S&P 500 is that the constituent companies are weighted by market capitalization. (Market price times the number of shares outstanding equals market capitalization.) As a result, movements of the very largest companies in the index have a disproportionate impact on changes in the index. At the moment, the five top spots are held by Apple, Microsoft, Amazon, Google, and Facebook, which combine to account for 19% of the total. As the big guys move, so does the S&P. It’s even more skewed when considering the top 10 companies, which altogether account for 26% of the total.
The S&P 500 can also be viewed on an equal-weighted basis. When doing so, the price movements are quite different. Over the latest one-year span, the S&P 500 as regularly viewed was up 57%, but on an equal-weighted basis, the gain was reduced to 45%. For the current year to date, the differential is even broader.
The comparison gets much more interesting when viewing the Wilshire 5000 Index, which is the widest measure of the U.S. equity market, including many of the smallest companies. For the year to date and latest year, returns from the Wilshire Index were similar to those of the S&P on an equal-weighted basis, but when measured over two and five years, the Wilshire Index had the highest returns. That, no doubt, was due to the more rapid growth of the smaller companies in the group.
When looking abroad, the proxies for developed markets and emerging markets are EFA and EEM, two exchange-traded funds from iShares. The results of these two have been dramatically different. Both have essentially gone sideways for the past decade and half, but more recently they have regained momentum and kept pace with the S&P. Given the generally more reasonable valuations found in these international markets, it is likely that they will provide more substantial returns going forward.
N. Russell Wayne, CFP®
Sound Asset Management Inc.
Weston, CT 06883
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