Despite a few rocky days recently, the US stock market is having a great year. But exactly how great depends on what you mean by “the stock market”.
Are you talking about the Dow Jones Industrial Average, the oldest and best-known measuring stick for the American stock market? If so, that one has risen more than 18 per cent over the last 12 months, a spectacular return. Or are you referring to the Standard & Poor’s 500-stock index, the benchmark for large companies used by many stock professionals?
If so, that market has been far less impressive, with a gain in the last 12 months of a little over 12 per cent. Or do you mean something else entirely?
The divergence between the two big indexes began in November, when the Dow started to surge ahead of the S&P 500. Though the shift in the indexes was little noticed at the time, the Dow has gained more than 20 per cent since then, while the S&P is up about 15 per cent.
A gap of this magnitude is unusual: The two indexes usually move within a percentage point or two of one another. Why has this happened?
To a surprising extent, the divergence depends on just two stocks, Apple and Boeing, and on the ways in which the two indexes are constructed. Both companies have had outstanding performances recently.
Boeing stock, which trades at about $235, is up roughly 50 per cent for the calendar year. Apple, which trades at roughly $157, has risen about 36 per cent.
But what may appear puzzling is that while Boeing has had a barely noticeable impact on the S&P 500, it has provided a gigantic lift to the Dow. According to data supplied by Howard Silverblatt, a senior index analyst at S&P Dow Jones Indices, Boeing accounts for one quarter of the Dow’s entire increase for 2017.
That’s almost double Apple’s contribution. Yet Apple is the most valuable company in the entire stock market; its market capitalisation is more than $800 billion.
Boeing, while hardly small, has a market capitalisation of only about $135 billion. Such considerations are critical in the S&P 500.
Stocks with a bigger market cap have a proportionately bigger impact on the index. That’s why it is known as a “market-weighted index”, and why professionals use it much more widely than the Dow.
“The S&P tells you much more about how the market is really doing,” said Jeremy J. Siegel, a finance professor and market historian at the Wharton School. “Modern indexes that track stock markets are generally market weighted.”
The Dow is not a modern index. It is old and simple, created more than a century ago by Charles Dow, who was the co-founder of Dow Jones and the first editor of “The Wall Street Journal”. For many, the Dow is synonymous with the American stock market.
“If you say, how many points did the market move today, you’re talking about the Dow,” Siegel said. “But it’s a crazy way to measure the market.”
Only 30 stocks are included in the index, which uses a measuring system so simple that it seems arbitrary: Stocks are weighted by price. That means that the highest-priced share of a stock — which happens to be Boeing at the moment — has the greatest sway in the index.
Consider the implications of using that kind of index. Imagine that you are creating a food index based on all of the items you have bought in the last year. You purchased one jar of caviar and 1,000 cans of tuna fish. In a price-weighted index, caviar will have the biggest overall impact because it’s the most expensive item you’ve bought, even though you spent far more money on tuna.
The rise and fall of caviar is the powerhouse that controls your price-weighted food index, even if you never buy caviar again in your life.
“No one would build a stock market index that way today,” Siegel said. “But remember, Charles Dow did it without computers, and it basically works. It tells you how the market performed and it requires relatively little calculation.”
It has some idiosyncrasies, though. “You can’t put a $1,000 stock in it,” he said. “You can’t put a stock like Amazon in it without all kinds of adjustments because its price is too high and it will change the index too much.”
Consider what the Dow looks like now. Boeing’s weighting in the index — based entirely on the price of a single share of Boeing stock — was 7.3 per cent, Silverblatt said.
Close behind were Goldman Sachs at a 7.07 per cent weighting; 3M, with a 6.47 per cent weighting; United Health, at 6.04 per cent; and McDonald’s, at 4.91 per cent.
Apple was only in sixth place in the Dow, with a weighting of 4.85 per cent. Because of this price-weighting system, Boeing has more than nine times the stature in the Dow as General Electric.
Yet GE’s total value — its market capitalisation — is much greater than Boeing’s.
No matter. Boeing has a far bigger impact on the Dow, and on “the market”, if we are using the Dow as a shorthand way of talking about all stocks, than GE does. Is there a better way of defining the stock market?
Absolutely. There are many other indexes. The S&P 500 does a good job of measuring large-capitalisation stocks but it misses thousands of smaller ones. For the purpose of measuring the entire US market, including small stocks, many academics and professional investors prefer another market-weighted index: the CRSP US Total Market Index maintained by the Center for Research in Security Prices at the University of Chicago.
Vanguard uses that index as the benchmark for its Total Stock Market Index Fund. The goal, Vanguard says, is to match “the investment return of the overall stock market.”
By that broader and no less precise definition, the market is not doing quite as well as either the Dow or the S&P would have you believe. The CRSP index is trailing the Dow by more than 2 percentage points this year, and is behind the S&P by more than three quarters of a percentage point.
That may be why your stock portfolio, if it is diversified enough to capture the entire market, isn’t turning in a performance as spectacular as the daily news reports may suggest. The problem may just be that everybody is talking about the Dow. They are not really talking about the stock market.
