There are times, like recently, that the markets make new highs. Wonderful! we think.
But when we look at some individual stocks, some are bouncing around their lows. So what gives?
Where To Look
When we hear “the market is making new highs,” we think in terms of broad market indexes. But these indexes are weighted. Which means that not all stock price movements are created equal.
What is Weighted?
There are several types of weighted indexes. A capitalization-weighted index means that a stock that has a larger market capitalization is represented with a larger portion of the index versus a stock that has a lower market capitalization. As a result, price movement of companies with larger market capitalization have a out-sized impact on the index.
Examples of market capitalization weighted indexes are the S&P 500, the Nasdaq Composite, and the Wilshire 5000.
The Dow-Jones Industrial Average is a price-weighted index that is calculated by adding the prices of one share of each company in the index, and dividing that total by a specific divisor. (The divisor is used to normalize spin-off, stocks splits, etc.) As a result, price movement of the higher priced stocks have an out-sized impact on the index.
The third type of inex is the equal-weighted index (also sometimes called unweighted index). This kind of index means all stocks in the index are treated equally: none are give a larger weight than others. While this seems more equitable, this kind of index places some smaller, slower growing companies with equal weight to some strong and growing companies. Whether this is desirable is an open question.
What to Do?
Which kind of index is appropriate to follow? There is no correct answer. The popular media broadcast the most popular indexes, so that is how we get the information we get.
The point to make is that indexes tend to exaggerate price movement. It is like the Richter scale used to measure earthquakes. A one point change, (say from a magnitude 6 earthquake to a magnitude 7), is massive. “Each whole number increase corresponds to an increase of about 31.6 times the amount of energy released, and each increase of 0.2 corresponds to approximately a doubling of the energy released.”
For better or worse, changes in financial indexes, while tending to exaggerate price changes, are not in such a specific relationship. Namely, a one point gain in a financial index does not necessarily correspond to any specific price change in any one stock.
Bottom Line
So it seems that there may be no real, accurate, specific, and reliable aggregate measure of what goes on in stock markets, except for the prices of the individual stocks one owns. And that is how I measure what goes on for me.
There is one number that I focus on. Since I am investing for income, the number I watch is my monthly dividend income. Since most all dividends are paid quarterly, my number is my quarterly income divided by three, or annual income divided by 12. And I measure that against my monthly expenses. Overall, what percentage of my monthly expenses can be covered by my dividend income.
When It Happens
So regardless of how the indexes do, I check the prices for the stocks I am interested in. If the stocks that I follow have started to decline, I check their prices versus their 52-week range. Those hitting at or near lows get my attention for possible additional purchases.
What’s your take on indexes? Let me know here.
The illustration is from the book of Japanese woodblock prints of silhouette art “No Shadow in Any Nook or Corner (Kuma naki kage) くまにき影” by Shibata Zeshin 柴田是真, published in 1867. Courtesy The Metropolitan Museum of Art.
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