I’ll Take Stock Market Indexes for $600
By Darren Nyce, CFA
Senior Research Analyst, Castle Investment Advisors®, LLC
If you were a contestant on America’s Favorite Quiz Show Jeopardy!® and one of the categories was “Stock Market Indexes” how well would you fare? Would you be able to come up with the correct Jeopardy!® question for the following answers:
- The most widely followed index in the world contains this number of stocks.
- This sector dominates the Nasdaq Composite.
- This country is the most heavily represented in the MSCI EAFE.
Every quarter we use a chart similar to the one below to recap the performance of the stock market. It typically references the returns of a few major market indexes over the most recent period as well as a few longer periods. But how much do you really know about these indexes that get quoted so freely in the financial media?
|Index||1st Qtr 2012||1 Year Return||3 Year
|Dow Jones Industrial Average||8.8%||10.2%||23.6%||4.2%|
|Barclays US Aggregate Bond||0.3%||7.7%||6.8%||6.3%|
- The S&P 500 is comprised of 500 of the largest companies that are representative of the U.S. economy, selected by Standard & Poor’s.
- This is a float adjusted cap weighted index, which means that the larger the company, the more weight it carries in the index. For instance, the 10 largest companies (2% of the total) account for 20.5% of the return while the 100 smallest (20% of the total) account for only 3% of the index return.
- The Russell Company takes the 3000 largest stocks, which encompass about 98% of all publicly traded stock, then breaks out the smallest 2000 to make up this index which is the most common index for small cap stocks.
Dow Jones Industrial Average
- The DJIA is the most watched stock index in the world, though it contains only 30 stocks.
- This is a price weighted index, which means that the higher the stock price, the more weight it carries in the index.
- This index, known for its emphasis on technology stocks, contains all of the stocks listed on the Nasdaq exchange (more than 3000) and is not limited to those that have U.S. headquarters.
- NASDAQ was originally an acronym for National Association of Securities Dealers Automated Quotation, that is no longer used.
- Morgan Stanley developed this index to measure the performance of stock markets outside of the U.S. and Canada.
- EAFE stands for Europe, Australasia, and Far East.
- This is also a market cap weighted index with stocks from the U.K. (22.4%) and Japan (21.6%) weighing most heavily.
Barclays U.S. Aggregate Bond
- Formerly known as the Lehman U.S. Aggregate Bond Index, this index is used to represent investment grade bonds being traded in the U.S.
- This index includes Treasuries, Agencies, Mortgage-backed, and corporate bonds, but excludes municipal bonds and Inflation Protected Securities.
Each of these has its advantages as well as its flaws, but overall they give a good picture of what is going on in the markets.
The market has gotten off to a great start in 2012 as is evidenced by the returns shown in the previous chart. In the calendar years 2008 – 2011, the S&P 500 experienced trading days that were down at least 1% an average of more than once every week; in the first 3 months of 2012, there was only 1 such down day for the whole quarter.
Which sectors performed the best? If you noticed in the chart on Page 1 that the Nasdaq Composite outperformed the other indexes, you would be correct to conclude that the technology sector was this quarter’s leader with financial stocks also doing quite well. On the bond side, high yield and emerging markets were this period’s top gainers.
Another interesting side story to the market’s performance is the Apple affect. Apple’s stock has been on a tear lately, rising more than 48% so far this year. In January, Apple surpassed Exxon Mobil to become the largest company in the world as measured by market capitalization (stock price multiplied by the number of shares outstanding). Earlier we mentioned that the S&P 500 is a cap weighted index, which means that Apple’s stock will have more impact on the index than any other. In fact, if you take away Apple’s performance from the S&P 500 for the quarter, the return would drop from 12.6% to 10.4%, pretty significant for one company.
Though Apple’s influence is large, 3.8% of the total weight, it is not the greatest in the index’s history. That distinction belongs to IBM, which accounted for 6.3% of the S&P 500 in the early 1980s. Around that same time frame AT&T counted for 5% of the index. The current top 10 influencers are Apple, Exxon Mobil, Microsoft, IBM, Chevron, GE, AT&T, Johnson & Johnson, Procter & Gamble, and Wells Fargo.
The market has gained a lot of ground in the last few quarters while the economic recovery has been slow but steady. As we look forward we have some expectation of a market correction in the coming months when we consider the following:
The increase in gas prices may inhibit the consumer from spending in other areas.
- While the market appears fairly valued based on forward EPS (Earnings Per Share) estimates, these estimates assume that profit margins will remain at record high levels.
- The ratio of corporate profits to GDP (Gross Domestic Product) is almost 70% higher than its historical average.
- The potential change in the political climate from the upcoming election.
- The lack of direction of the future tax situation, combined with potential for mandatory spending cuts beginning in 2013 foster a sense of uncertainty.
- Market participants are concerned that although progress has been made, the European crisis is not yet over.
- Higher numbers of corporate executives are selling their stock.
- While the headline unemployment rate is dropping, there are still not enough jobs being added to the economy – there were 8.8 million jobs lost during the recession and 3.9 million jobs gained since.
We concur with most estimates that expect economic growth to continue but at a slower pace than usual. And so we generally favor lowering equity exposure in the short term, while we wait for a correction to provide more favorable valuations. These uncertain times confirm our belief in the importance of investment portfolios that are appropriately diversified across several asset classes.
We at Castle Investment Advisors® remain committed to placing our clients’ interests first and using our professional skill and judgment to serve your financial needs. Thank you for the opportunity to partner with you and your family. If you have any questions or topics that you would like to discuss, feel free to contact any of our team members.
Castle Investment Advisors®, LLC Investment Team
Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation.
This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change.
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