The Meaninglessness of the Stock Market Index in a Digital World

https://www.theatlantic.com/technology/archive/2018/06/the-meaningless-of-the-stock-market-index-in-a-digital-world/563345/

by collapse • 8 years ago

120 79 8 years ago

theatlantic.com

tanderson923• 8 years 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• 8 years 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• 8 years 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• 8 years 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• 8 years 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/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.

actsasbuffoon2• 8 years 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.

abakker2• 8 years 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.

arawde• 8 years ago

On a related note, there are a _lot_ of indices. FT reports that there are over 3 million stock indices, for ~50k public stocks [0]. You can make an index with basically anything in it. There are indices for emerging markets, for the Gulf region, for companies in Mexico, for companies which qualify as ESG (environmental, social, and governance) criteria. There are indices of stocks that historically perform well in periods of rising interest rates, and there are indices for the Eurozone.

The ETFs just build on top of the index. In almost every prospectus, there is some kind of note about which index it is. You can go look at how the index is arranged, and there are sometimes multiple funds that track indices in the same sectors, with different weights. If you're not happy with the amount of Berkshire in your financials ETF, you can go find a fund which uses a different index and buy that instead.

If anything, a stock market index is _more_ valuable in a digital world, because it effectively adds a layer of abstraction to the typical notion of investing.

[0] https://www.ft.com/content/9ad80998-fed5-11e7-9650-9c0ad2d7c...

21• 8 years ago

All the professionals use the S&P 500 index.

The Dow Jones index is used only by the popular non-financial press.

imcoconut• 8 years 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• 8 years 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_theslob6462• 8 years ago

Would be curious to see a word frequency count of both in the WSJ.

baldfat3• 8 years 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/warr...

anoncoward1115• 8 years 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)

baldfat3• 8 years ago

Warren bet that the S&P 500 would out perform a managed Hedge Fund.

orenht• 8 years ago

I think it's not a one-time-investment at the beginning which is being measured, but a DCA (Dollar Cost Averaging) over a long period.

xkjkls5• 8 years ago

Ted Seides (who was on the other side of the bet) actually has some interesting counterpoints to make about it: https://www.bloomberg.com/view/articles/2017-05-03/why-i-los...

Marazan• 8 years ago

Not really.

He got beat fair and square and there are no excuses.

The whole point is hedge funds should do better otherwise what's the point of the management fees.

And if the point is to do worse in a rising market and then beat a falling market I can do that by putting 80% money in the S&P Tracker and 20% in cash and I won't charge a massive fee to do so.

pembrook• 8 years 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.

vpribish2• 8 years 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• 8 years 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• 8 years ago

The sum of discounted future cash flows is present value.

tamaharbor2• 8 years ago

There are a lot more than 3500 publicly listed corporations.

tamaharbor2• 8 years ago

There are a LOT more than 3500 publicly listed corporations.

lotsofpulp• 8 years ago

Bloomberg says 3600:

https://www.bloomberg.com/view/articles/2018-04-09/where-hav...

xkjkls5• 8 years 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.

vpribish2• 8 years ago

and they are willfully ignoring the OTC market which has 10k+

ScottBurson• 8 years 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• 8 years ago

What’s the value of the company if not assets + all future earnings?

closeparen• 8 years ago

The market clearing price.

xkjkls5• 8 years ago

I mean, that's the theoretical value that you should pay for it, but markets don't always exactly match theory.

cityhomesteader• 8 years ago

What about debt/liability?

I guess you might be referring to Enterprise Value ( EV ).

https://www.investopedia.com/terms/e/enterprisevalue.asp

Ultimately, the value of a company is what someone is willing to pay for it. So you could argue the value is EV + Premium.

Keep in mind that there is a bazillion ways of valuing a company. People look at growth potential of the company, the growth potential of the company's industry, the competition, external risks, buyout potential, etc. It's part business, part mathemagic and part voodoo.

windows_tips• 8 years ago

What's the value of a 'future earning'?

aaavl28213• 8 years ago

Your idea of "earnings per dollar of market cap" is essentially the same as "earnings yield", or inverse of the P/E ratio, which is indeed much more meaningful than EPS

Earnings yield is a measure of how expensive a unit of earnings is, and can be compared across companies as a heuristic for "cheapness".

Another metric is free cash flow yield: free cash flow / market cap. Using operating free cash or operating profit like EBITDA gets you the cost of operating cash flow excluding non-operating stuff like interest, taxes and non cash depreciation expense

You can also use enterprise value as the denominator (market cap plus debt less cash) to capture the full picture of a company's capitalization

By buying groups of stocks based on these metrics, rather than just index funds, you can blend aspects of passive and active investing. This is called "smart beta" and is an interesting emerging strategy

A good primer is "the little book that beats the market". The strategy is to buy "cheap and good" stocks and just hold them. Cheap is defined by high EBIT / EV (lots of earning power per unit of capital) and good by high ROIC (the business can turn money into more money). So you filter by these two metrics, then buy the top x companies, buying one stock / month over a year to mitigate timing risk, and hold

melling2• 8 years ago

I believe that you need to buy about 20-30 of these companies then hold each for about a year, to get long-term capital gains, then reevaluate. Greenblatt claims that statistically this will work.

The Magic Formula:

https://en.m.wikipedia.org/wiki/Magic_formula_investing

Has anyone tried it?

ISL• 8 years ago

One must be careful to avoid a "value trap". Occasionally, a company is inexpensive for a reason, and that reason can be hard to discern at a glance.

derriz• 8 years ago

Regarding "Instead of EPS, we should be talking about earnings per dollar of market cap", isn't that what the P/E ratio measures? Although, strictly speaking you are suggesting the reciprocal - an E/P ratio.

I believe P/E ratios are far more widely used for comparing companies.

EPS isn't a completely useless measure - it can be useful to shareholders in the specific company to provide some anchor for judging dividend policy and for comparing performance over time for that particular company.

But I agree that EPS is a useless measure for comparing different companies.

__blockcipher__4• 8 years ago

We should never be talking about earnings per dollar of market cap (PE, as you've correctly noted) - the far superior metric is fcf per dollar of market cap. (Even FCF isn't a flawless metric, since it can be affected by one-offs, but those are generally easy to account for, whereas earnings being a pure accounting metric is vulnerable to all kinds of fuckery)

codetrotter• 8 years ago

Likewise people sometimes make the mistake of comparing prices for different cryptocurrencies. In the case of cryptocurrencies one should look at the market cap, which is the current price multiplied by the amount of coins or tokens available.

obelix_• 8 years ago

And that is why psycologists are winning Nobel's for economics these days. Tomorrow they will hopefully play a bigger role in engineering and tech.

shorttime• 8 years ago

I disagree. A share is worth a portion of the business. That is a defined unit. The share price is what people will pay for a share of the piece of company. Baked into the price is the underlying assets (real value) in addition to the fuzzy speculation piece.

The share prices can be analyzed by looking at the financial reports. True value can be assessed by looking at assets minus liability, debts, dividend payment, etc.

This value per share then is compared to the buying price. There is a lot of speculation built into the price now a days. An investor does not have to buy at this real value + speculation price, the investor can sit it out. People are willing to pay for a share of this company, a non-defined amount, it's the only way to continuously offer a share of the company for sale.

harry8• 8 years 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

rossdavidh• 8 years 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.

ta12345678902• 8 years 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_theslob6462• 8 years 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]

ta12345678902• 8 years 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

The Meaninglessness of the Stock Market Index in a Digital World

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