SINGAPORE (Apr 9): The global stock market selloff, which dragged many bellwether market indices into the red in 1Q2018, continued to hold sway as we entered the second quarter. With volatility staying elevated amid myriad uncertainties — notably on global trade and tech industry regulations — the question on the forefront of investors’ minds is “Are we near the bottom yet?”

For those reading the charts, the signs are ominous. Last week, the Dow Jones Industrial Average (Dow) breached its 200-day moving average, albeit briefly, in intraday trading. If it closes below this key psychological support level, that will put it in bearish territory for technical analysts. Not so long ago, the Dow was making successive record all-time highs. It has certainly been quite a reversal in a little over two months.

The Dow is the world’s most closely watched benchmark index and a leading indicator for all other stock markets. So, understanding how it works — and therefore, how useful it actually is as a predictive tool — is important.

Since the end of the global financial crisis, the Dow has climbed inexorably higher — from 8,776 points at end-2008 to an all-time high of 26,617 in January 2018. That was a threefold increase in just 10 years. And it was not just the absolute quantum of gains that caught the world’s attention but also the steepness of its rise. Case in point: The index rose nearly 5,000 points in 2017 — only to add another 1,897 points in less than a month to its record high on Jan 26.

The magnitude of gains, unsurprisingly, brought about a chorus of cautionary narratives — chiefly, that the US market is overvalued by all historical yardsticks. This may well be true, and we have demonstrated previously how individual valuations for Dow component stocks have risen, driven by the growthof exchange-traded funds (ETFs). And, indeed, the selldown in February and March appears to lend credence to these narratives.

But I am convinced that comparing the current index level to the past is neither meaningful nor useful. Why? Because the components of the Dow changes and, over time, it will be akin to comparing apples with oranges.

The bellwether index was created in 1896 by Charles Dow, a reporter and one of the founders of Dow Jones & Co (which publishes The Wall Street Journal, among others).It now comprises 30 companies that are meant to represent key sectors of the US economy (though this is not necessarily the case).

Crucially, the decision to include or exclude a stock is not based on any transparent and objective criteria but at the discretion of its owner. I would hardly believe any new inclusion would not be companies with better outlook and growth and a reflection of how the economy is evolving.

Case in point: Eastman Kodak Co used to be a component of the Dow. At the beginning of 2000, its shares were trading at almost US$50. By the time it was dropped from the index (replaced with Pfizer), in April 2004, its price had fallen to less than US$23. Kodak is a prime example of a company that was so focused on one key product (maintaining its lucrative film business despite inventing the digital camera in 1975) that it missed the forest for the trees. It eventually filed for bankruptcy protection in 2012.

More recently, Apple replaced AT&T in March 2015 and has since outperformed the latter by well over six times to-date.

What I am trying to say is, there is a natural upward bias to the Dow over time.

Since 2000, there have been 15 changes in the Dow component stocks. In other words, in just the past 17 years, half of the companies represented in the Dow are no longer the same companies.

Furthermore, the Dow is a price-weighted index. In essence, the index is simply the average price of the 30 component stocks. It gives no regard to the size of the company and its market capitalisation. So, a higher-priced stock will have an outsized impact on index movements than a lower-priced stock, even if the latter has a much larger market capitalisation.

For instance, a 1% gain for a US$1,000 stock (US$10) will move the Dow by 10 times more (in absolute point terms) than a 1% gain for a US$100 stock (US$1). Therefore, if we were to keep replacing the Dow with higher-priced stocks, it will result in bigger and bigger point movements.

Between 2000 and 2008, only two of the seven switches were for higher-priced stocks but, since 2009, five of the eight changes saw the inclusion of stocks that had higher absolute stock prices (see Table 1).

In Chart 2, we created a hypothetical 2000 Dow Index (by tracking the share prices for the 30 companies that made up the Dow in 2000) and compared it against the actual Dow Total Returns Index (which, as we know, has seen 15 changes since 2000).

The 2000 Dow Index shows where the index would be today if there were no change to its component companies. Note that we used the Dow Total Returns Index instead of the normal Dow that you read in news headlines for this comparative purpose. This is to account for dividends and other corporate exercises, for which share prices are adjusted.

The divergence between the two indices grew increasingly larger after 2008.

One could argue that the difference of about 20,000 points on the Dow Total Returns Index, or nearly 37%, was “inflated” by both changes to the component companies as well as the rise of ETFs. Passive funds invest in components stocks, whichever that happens to be in the index, without regard to their businesses or fundamentals.

That said, I am not disputing the value of indices to gauge marketwide performances over the short term. And while the focus of this article is only the Dow, our arguments are valid for all other indices as well. The moral of this story? History is not always a good guide. We should keep this in mind the next time the Dow makes a fresh record high, and it will.

And to the chartists, or those who use price charts to predict or find a trend, I am at a loss for words. It is like taking the height of a child as she grows over time, except that each time, you are measuring the height of a different child.

The Global Portfolio is up 4.7% since inception and continues to outperform the benchmark index, which is now down 1.5%. I made no change to the portfolio.


Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.

This article appeared in Issue 825 (Apr 9) of The Edge Singapore.

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