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First in our discussion, I would like to take a moment to introduce you to what you likely already know as a reliable benchmark of markets: The Dow Jones Industrial Average (DJIA). As most are likely aware, the Dow is comprised of thirty of the largest major public companies within the United States. In essence, the DJIA is an 'average' of thirty stocks, all with 'large cap' weighting, meaning their respective markets caps generally exceed $5 to $10 billion. As the Figure 7.1 shows, the DJIA is comprised of large name companies most would recognize in a heartbeat.
Figure 7.1
On first glance, it makes sense to trust the Dow Jones Industrial Average as a valid benchmark to track the U.S. economy and the sentiment of investors through the daily buying and selling of the index. Moreover, it is also likely fair to say that then the Dow moves up, investors feel good about the economy and when the Dow falls, investors feel the economy is in trouble.
Not so fast though, there's something else happening here that savvy traders will likely want to be aware of. Some argue that measuring the 'average' of thirty stocks is not a true snapshot of the whole economy and thus, does not accurately measure the present-day health of all sectors and business within the United States. However, in our never-ending pursuit of truth - and the true underpinnings of volatility - we brush off the typical arguments both for and against the DJIA in exchange for greater understanding of a perhaps larger (hushed) problem looming under the surface.
The problematic issue with the DJIA actually has nothing to do with the 'total amount' of companies that make up the index… Rather, the knotty concern with the DJIA is really in the way the index calculated from the start. Did you know there are basically five methods used to calculate indices?
They are:
• Market Capitalization Weighted Indices • Modified Market Capitalization Weighted Indices • Price Weighted Indices • Fundamentally Based Stock Indices • Attribute Weighted Indices
Can you guess which of the previous five methods is used to calculate the Dow Jones Industrial Average? If you guessed 'price weighted', you guessed correctly.
Traditionally, price weighted indexes are calculated by summing the prices of all components and then dividing by the total. When the Dow kicked off way back in 1896, there were only 12 initial components. Charles Dow added up the prices of all the companies and then divided by 12.
That's it, nothing to it!
Figure 7.2
Over the years, 18 more companies were added to develop the present total of thirty components. There's more to the story though…
The real meat to this tale is in the math behind how the Dow is calculated…
Let's take an example where we have 10 companies in an index:
Looking at the Figure 7.2, we see that the total of all prices equals $355. Moreover, by taking the sum and then dividing by the total (10), we end up with an average price of $35.5, which would be the 'index value'. But let me ask you a question, what happens one of the stocks split in the index? Would it change the index value? You bet it would.
Figure 7.3
Moreover, given that the more expensive a stock becomes, the more likely it is to split, unless of course, it's Berkshire Hathaway.
For the sake of example, let us assume the most expensive stock in our list, Company 5, splits. Instead of calculating the index value with the previous $100, if we made no other adjustments, we would use the post split price of $50 in our sum of all the prices.
The new sum of $305 divided by the total (10), would give us a new index value of 30.5, versus the pre-split index value of 35.5.
Because of the split, the index value is now 14% lower than it was before the split, however, nothing fundamentally changed in the stock and really, not a single share was sold in the whole process.
To overcome the loss in index value should a split occur, the Dow Jones Company instituted the use of a divisor.
Figure 7.4
The divisor is calculated by taking the post spilt total of the prices and then dividing by the original value. For example, if we had 10 $100 stocks and one component split, the divisor calculation would be simply to divide $950 by the original $1000, which would give us a divisor of 0.95.
Then, to calculate the actual index, the post split sum of all stock prices is divided by the divisor, which provides a more accurate price of the index.
In the case of our previous example, if we utilize a divisor we would divide the post-split sum of prices ($305) by the new divisor (0.87), bringing us back to original total of $350. Then dividing by 10, just like in our pre-split example, we would end up with a correct index value of 35.5.
Thus, the divisor brings the sum of all prices (reflecting splits) back to the correct pre-split summed value of prices…for us to then divide by the total components in the index. The methodology I have just shown is a Price Weighted Index.
Sounds reasonable correct?
Not so fast. There is an inherent issue with this method.
Foremost, as time passes and more companies within the index split, the divisor becomes smaller and smaller… Normally small numbers aren't too scary right? Wrong.
Every time a stock splits in the Dow, the divisor becomes more minute, thus creating even more volatility within the index.
Did I just use the word volatility? Yes I did. Volatility is in fact created within the Dow Jones Industrial Average because of the way it is calculated.
Let me explain… As of June 9, 2009, the Dow Jones Company announced:
The Dow Jones Industrial Average will be calculated with a new divisor prior to the open of trading on Monday, June 8, 2009. The divisor for the Dow Jones Industrial Average changes to 0.132319125 (from 0.125552709) as a result of the following actions:
• General Motors Corp. (Pink Sheet: GMGMQ) is to be deleted from the Dow Jones Industrial Average.
• Cisco Systems Inc. (NASDAQ: CSCO) is to be added to the Dow Jones Industrial Average.
• Citigroup Inc. (NYSE: C) is to be deleted from the Dow Jones Industrial Average.
• Travelers Cos. Inc. (NYSE: TRV) is to be added to the Dow Jones Industrial Average.
After 113 years, so many stocks have split in the Dow Jones Industrial Average, the divisor is now at an extremely low 0.132319125.
What does this mean to you?
Think about it for a moment, if a stock moves up $3 in a single day, the occurrence would add 22.7 points to the DJIA closing value for that day. ($3 / 0.132319125 = 22.7)
Let's take a moment and step back from the situation though…to consider the 'common sense' behind what's happening. If you have a $10 stock that moves $3 in one day, the stock would have individually gained 30% in the session. However, if you have a $100 stock that moved $3 in one day, the stock would have gained 3% in one session.
Which is more likely- a stock gaining 30% in one session, or a stock gaining 3% in one session?
The common sense answer is obviously that it is more likely that a $100 stock will move $3, over a $10 stock. Thus, because of the way the Dow Jones Industrial Average is calculated, higher price stocks within in the index have greater influence in the total value of the index. What's more, the higher stocks move (within the index), the more rapidly the index value climbs…or falls.
To gain the upper hand on the Dow, one could theoretically track the top ten most expensive stocks on a daily basis for greater guidance into the indexes' potential movement, versus just tracking the index by itself. Why?
Think about it for a moment... If higher price stocks have greater probability of larger price swings, and prices really have the greatest impact on the index value, it would makes sense that we would more closely watch the stocks that see greater day-to-day price swings, over the lesser price components.
I will explain this in detail in a moment, first though, please note that as of June 18, 2009, the components (and respective prices) of the DJIA were:
Figure 7.5
Now, in Figure 7.6, please note the 'total impact on index value' of a one-day 1.5% gain in the top 10 most expensive stocks, over the top 20 least expensive components (Figure 7.7).
Figure 7.6
All things being equal, a 1.5% move up in every stock in the Dow Jones Industrial Average would equate to a +128-point gain in the total index closing value.
Of the +128-point gain, the top 10 most expensive stocks would have contributed to 54.93% of the gain, while the bottom 20 would have contributed to 45.07% of the gain. Ironically, the top 10 stocks moved the exact same percentage as the bottom 20 and yet have greater 'weight' on the total index value.
Figure 7.7
What we're talking about here is an index that is preloaded for volatility, especially if old market adage of higher prices over the long haul holds true. Fact is, as the prices of the individual components in the DJIA climb, the more volatile the index becomes, given the present price/divisor paradigm.
With the aforementioned in mind, we can assume that the higher the DJIA moves:
1. In terms of point swings, the daily moves will be greater.
2. Media hype will only increase in years to come, as 200, 300, 400 and 600 point swings begin to surface -daily- in the index.
3. The index has been 'artificially pre-loaded' to gain-ground.
Point number three in my last statement hopefully caused a few readers to raise their eyebrows… I did -in fact- say 'artificially pre-loaded to gain ground.'
Please allow me a moment to clarify… In the fall of 2007, the Dow Jones Industrial Average hit an all time high of 14,198.10, obviously before U.S. mortgage markets fell through the floor, and before the entire financial crisis really unfolded. By June of 2009, the DJIA was down about 40% from the 2007 high.
Funny thing though…if you remember the divisor announcement a few pages ago, we also know in June of 2009, two stocks were removed from the index, and were replaced by two new companies.
The announcement read:
• General Motors Corp. (Pink Sheet: GMGMQ) is to be deleted from the Dow Jones Industrial Average. • Cisco Systems Inc. (NASDAQ: CSCO) is to be added to the Dow Jones Industrial Average. • Citigroup Inc. (NYSE: C) is to be deleted from the Dow Jones Industrial Average. • Travelers Cos. Inc. (NYSE: TRV) is to be added to the Dow Jones Industrial Average.
Let's take a moment to consider the reality of the situation here… In October of 2007, General Motors posted a relative high of $41.93, while Citigroup tagged a high of $45.09 in the same month…
By June of 2009, General Motor's stock was trading at $1.75, while Citigroup was trading at $3.17.
In all, from October of 2007 to June of 2009, General Motor's stock lost 40 points (-95.8%), while Citigroup had peeled off 42 points (-93%). Here's the thing though, if you remember our discussion a moment ago about the DJIA being 'price weighted', using the pre-June 9, 2009 divisor of 0.125552709, the total point declines of General Motors and Citigroup contributed to 653 points of the 5,658.37 points lost in the DJIA, since the October 2007 highs.
So how would the Dow ever climb back to a level where media and investors would ever pay close attention to the index again, if Citigroup and General Motors stocks are likely to stay under $10 for a long, long time? What do you think the solution is?
General Motors and Citigroup were 'black eyes' for the Dow, and considering it is much, much tougher for a $40 stock to add $10, versus a $100 stock, both stocks were poised to remain as major drags on the index for years. What I'm saying is if a few of the stocks in the index have been beat up considerably (like fallen under $10), wouldn't the occurrence make it much harder for the Dow to ever post new highs again, with the cheaper stocks weighing heavily on the total index value?
You know it.
Dump the losers and replace them with stocks that have a better chance of gaining ground. The higher the new stocks climb, the more points they will add to the total index value.
Bingo! General Motors and Citigroup were kicked to the curb and replaced by Cisco and Travelers.
Fact is, as of June 9, 2009, because Citigroup and General Motors were booted from the Dow, the index now stands a greater chance of recouping losses (and eventually making new highs) than if the flailing bank and auto manufacturer were still a part of the benchmark index.
When the Dow eventually climbs back to new highs, media will likely tout 'the bull is back' or something like 'you can't keep the Dow down' (or whatever), however, media will likely forget to mention the mega-money center bank that was replaced by a property & casualty insurance company and the 'American as apple pie' auto-manufacturer that was replaced by a network and communication devices company.
What's more, when considering that there's no longer any auto-manufacturers in the Dow now, it seems awkward to assume the index truly reflects a fair breadth of products used in the calculation of consumption and GDP growth – in America. At the end of the day, if every time the Dow pulls back in an economic hiccup, 'beat-down' stocks are replaced by others that hold greater potential to ascend, the event really means the index will likely make new highs –again- in the years to come, but not truly reflect the American economy, as it is said too.
Analysts will continue to tout 'the investor who bought Dow stocks and held them over the past fifty years has seen his portfolio continually climb, even with the crash of 1987, the dot.com bomb and the financial crisis.'
But what they won't tell you is part of the reason the Dow is able to keep making new highs –decade after decade– is the lesser performing components are dumped like a bad date, any time the kitchen gets hot.
Eventually, the Dow will hit new highs and day-to-day volatility (in terms of price swings) will be greater than ever. Really, we're talking about preloading volatility into markets.
In a few years, when the Dow is back at highs… Citigroup and General Motors will likely still be in the gutter trying to recover.
There's even more to the story though…the volatility story, I mean… As I've just pointed out, the way the DJIA is calculated –and preloaded- is all geared to help the index constantly make new highs over time. New highs mean new press and new press means more exposure. It's about maintaining 'benchmark status', while keeping investors interested in…investing. However, much like our memories are easily influenced by media (in recollection of historical events) the Dow example is another instance of 'important information' completely passing by the general public. Given the larger financial crisis, political events of the day and everything else one must constantly worry about, why would the calculation of an index ever even be important to take note of? What we're really talking about is the total mass of information required for investors to truly stop and mark as important. In the 21st Century information paradigm, unless an event has enough 'sauce' to spark significant fear (loss) or exuberance (greed) within individuals, the information passes like a shooting star on a cloudy night. Eventually, the DJIA will likely hit new highs and media will again gawk and squawk about the event, thus sucking investors into the poison tree –yet again- and of course, eventually the economic cycle will take a downward turn and those same investors will see their wealth decrease, as major indices take another nosedive.
I'm not saying that we shouldn't invest…after all, now that the DJIA has been 'reloaded' for possible upside, the present day actually appears to be a decent time to buy…at least if the U.S. Dollar doesn't plummet in the near future, due to the loss of credit quality of U.S. Treasuries, based on excessive spending by the Government…but that's another conversation.
The point, however, is we can certainly invest in markets and indices, so long as we are fully cognizant of the volatility paradigm. Moreover, we must also recognize that the larger problematic issues behind how the delivery and reception of 'information' has changed in the 21st Century, while actively seeking out information that could present future volatility – ahead of time.
Printed in Volatility Illuminated - July 2009
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