Security Market Indicator Series

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Security Market Indicator Series

• (Stock market indexes,
• their construction
• and use)

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Stock Markets

• Most everyone follows the stock markets
• Daily news media commonly report the daily value
  and the change in U.S. market indicator series
  such as the Dow Jones Industrial Average and the
  Down Jones Transportation Average and the NASDAQ
  Composite.
• In Canada we commonly hear about the TSE (Toronto
  Stock Exchange) 300 Composite Index and the CDNX
  (Canadian Venture Exchange)
• But what are these measures? How are they
  conceived? What do they measure? How can we use
  them?

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Security-market Indicator Series

• The term security-market indicator series is a
  more correct term to use when describing the
  whole range of stock market indices and
  averages
• this is because not all indicator series is
  constructed as an index
• For example the DJIA (Dow Jones Industrial
  Average) is an average of 30 large blue-chip
  stocks traded on the NYSE (New York Stock
  Exchange)
• The TSE (Toronto Stock Exchange) 300 is a
  composite index made of the the 300 largest
  value-weighted stocks publicly traded on the
  Toronto Stock Exchange

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What is a Blue Chip Stock?

• Blue chip stocks is a general term that is
  loosely applied to companies that are generally
  considered to be leaders in their industry, are
  typically very large in terms of market
  capitalization (the number of shares outstanding
  multiplied by their current market price), are
  considered to be mature (ie. they are not
  necessarily rapidly growing in terms of sales or
  stock price) and often pay a substantial and
  consistent cash dividend.
• Examples include IBM, American Express, etc.
• Why not do an internet search and find out what
  30 stocks are included in the DJIA?

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DJIA

• Companies included in the average are those
  selected by Dow Jones Company, publisher of the
  Wall Street Journal
• The composition of the average changes over time
  as companies are dropped because of a merger or
  bankruptcy has occurred, because a companys
  trading activity is low, or because a company not
  in the average becomes very prominent.
• When a company is replaced by another company,
  the average is readjusted in such a way as to
  provide comparability with earlier values.

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Use of Security Market Indexes

• As benchmarks to evaluate the performance of
  professional money managers
• to create and monitor an index fund
• to measure market rates of return in economic
  studies
• for predicting future market movements by
  technicians
• as a proxy for the market portfolio of risky
  assets when calculating the systematic risk of an
  asset

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Differentiating Factors in the Construction of
Market Indexes

• Because the indicator series are intended to
  reflect overall market price changes of a group
  of securities, it is necessary to consider which
  factors are important in computing an index that
  is intended to represent a total population.
• Each indicator series will be built upon
  conscious choices on the following issues
• SAMPLE
• WEIGHTING SAMPLE MEMBERS
• COMPUTATIONAL PROCEDURE

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Differentiating Factors in the Construction of
Market Indexes

• SAMPLE - the size of the sample, the breadth of
  the sample, and the source of the sample used to
  construct a series are all important
• WEIGHTING SAMPLE MEMBERS - three principal
  weighting systems are (1) price-weighted (2)
  value-weighted (3) unweighted (equally weighted)
• COMPUTATIONAL PROCEDURE - one alternative is to
  take a simple arithmetic average of the various
  member in the series. Another is to compute an
  index and have all changes, whether in price or
  value, reported in terms of the basic index.
  Finally, some prefer a geometric average of the
  components rather than an arithmetic average.

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Price-Weighted Series

• A price-weighted series is an arithmetic average
  of current prices, which means that index
  movements are influenced by the differential
  prices of the components.
• DJIA
• the Dow Jones Industrial Average is the
  best-known price-weighted series and is also the
  oldest and most popular stock-market indicator
  series.
• It is computed by totaling the current prices of
  the 30 stocks and dividing the sum by a divisor
  that has been adjusted to take account of stock
  splits and changes in the sample over time.

Price-weighted series
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Example of Change in DJIA Divisor when a sample
stock splits

• After Three-for-One
• Before Split Split by Stock A
• Prices Prices
• A 30 10
• B 20 20
• C 10 10
• 60 3 20 40 X 20
• X 2 New Divisor
• when a stock splits, the divisor becomes smaller
  as shown.
• The cumulative effect of splits can be derived
  from the DJIAit was originally 30but as of July
  1999 it was 0.197405

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Price-weighted series
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Example of the Impact of Differently Priced
Shares on a Price-Weighted Series

• Period T 1
• Period T Case A Case B
• A 100 110 100.7
• B 50 50 50
• C 30 30 33
• Sum 180 190 183
• Divisor 3 3 3
• Average 60 63.3 61
• Percent Change 5.5 1.7
• because the series is price-weighted, a
  high-priced stock carries more weight than a
  low-priced stock.

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Price-weighted series
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Citicisms of the DJIA

• Limited sample size
• 30 nonrandomly selected blue-chip stocks make up
  the average
• the stocks selected are the largest and most
  pretigious companies in various industries.
• The DJIA, therefore, probably reflects price
  movements for large, mature, blue-chip firms
  rather than the typical company listed on the
  NYSE
• Several studies have pointed out that the DJIA
  has not been a volatile as other market indexes
  and that the long-run returns on the DJIA are not
  comparable to other NYSE stock indexes.

Price-weighted series
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Citicisms of the DJIA ...

• Weighting Scheme
• because the DJIA is price weighted, when
  companies split their stock, their prices
  decline, and therefore their weight in the DJIA
  is reduced - even though they may be large and
  important.
• Therefore, the weight scheme casues a downward
  bias in the DJIA, because the stocks that have
  higher growth rates will have higher prices, and
  because such stocks tend to split, they will
  consistently lose weight within the index.

Price-weighted series
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Value-Weighted Series

• A value-weighted series is generated by deriving
  the initial total market value of all stocks used
  in the series
• Market Value Number of Shares Outstanding
  Current Market Price
• This initial figure is typically established as
  the base and assigned an index value (the most
  popular beginning index value is 100, but it can
  vary - say, 10, 50).
• Subsequently, a new market value is computed for
  all securities in the index, and the current
  market value is compared to the initial base
  value to determine the percentage change, which
  in turn is applied to the beginning index value

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Value-Weighted Series

• In a value-weighted series, there is an automatic
  adjustment for stock splits and other capital
  changes (since the decreased price of the share
  is offset by an equal and opposite effect of an
  increase in the number of shares outstanding).
• In a value-weighted index, the importance of
  individual stocks in the sample depends on the
  market value of the stocks. Therefore, a
  specified percentage change in the value of a
  large company has a greater impact than a
  comparable percentage change in a small company.

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Example of a Computation of a Value-weighted index

• Stock Share Price Number of Shares Market Value
• December 31, 1999
• A 10.00 1,000,000 10,000,000
• B 15.00 6,000,000 90,000,000
• C 20.00 5,000,000 100,000,000
• Total 200,000,000
• Base Value Equal to an Index of 100
• December 31, 2000
• A 12.00 1,000,000 12,000,000
• B (2 for 1 split) 10.00 12,000,000 120,000,000
• C (10 stock dividend) 20.00 5,500,000 110,000,000
  
• Total 242,000,000
• New Index Value Current MV / Base Value
  Beginning Index Value
• 242 M / 200 M 100 1.21

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Value-weight Indexes

• Price changes for the large market value stocks
  in a value-weighted index will dominate changes
  in the index over time.
• This value-weighted effect was prevalent on U.S.
  stock markets (NYSE, OTC) in 1998 when the market
  was being driven by large growth stocks - that
  is, almost all of the gain for the year was
  attributable to the largest 50 of the SP 500
  Index.

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Value-Weighted SeriesThe TSE 300 Composite

• TSE 300 Composite Index is a value-weighted
  series
• 300 stocks (comprised of 14 subindexes)
• weights of the stocks is based on market
  capitalization adjusted for major shareholders
• Base year 1975
• Base value of the index 1000

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TSE 300 Composite Index Recent History
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TSE 300 Composite Index The 14 sub-indexes -
04/06/01

• 1. Metals and Minerals
• 2. Gold Precious Metals
• 3. Oil Gas
• 4. Paper Forest Products
• 5. Consumer Products
• 6. Industrial Products
• 7. Real Estate
• 8. Transportation Environmental Services
• 9. Pipelines
• 10. Utilities

• 11. Communications Media
• 12. Merchandising
• 13.Financial Services
• 14. Conglomerates

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TSE 300 Composite Index Sub-indexes and
components - 04/06/01

• 1. Metals and Minerals
• integrated mines
• mining
• 2. Gold Precious Metals
• 3. Oil Gas
• integrated oils
• oil gas producers
• oil gas services
• 4. Paper Forest Products
• 5. Consumer Products
• food processing
• tobacco

• Distilleries
• breweries Beverages
• Household Goods
• Biotechnology/Pharmaceuticals
• 6. Industrial Products
• steel
• fabricating engineering
• transportation equipment
• technology-hardware
• building materials
• chemicals fertilizers
• technology -software
• autos parts

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TSE 300 Composite IndexSub-indexes - 04/06/01 ...

• 7. Real Estate
• 8. Transportation Environmental Services
• 9. Pipelines
• 10. Utilities
• telephone utilities
• gas/electrical utilities
• 11. Communications Media
• broadcasting
• cable entertainment
• publishing printing

• 12. Merchandising
• wholesale distributors
• food stores
• department stores
• specialty stores
• hospitality
• 13. Financial Services
• banks trusts
• investment companies funds
• insurance
• financial management companies
• 14. Conglomerates

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TSE 300 Composite IndexSub-indexes - 04/06/01
examples

• 7. Real Estate
• ACK - Acktion Corp
• BEI - Boardwalk Equities
• TZH - Trizec Hahn Corp

• 12. Merchandising
• wholesale distributors
• FTT - Finning International Inc.
• RCH - Richelieu Hardware Ltd.
• UNS - Uni-select Inc.
• 14. Conglomerates
• BNN.A - Brascan Corp
• CP - Canadian Pacific Ltd
• OCX - Onex Corporation SV
• POW - Power Corporation of Canada SV

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TSE

• For further information on the Toronto Stock
  Exchange go to
• http//www.tse.com
• go to the periodicals in the Chancellor Patterson
  Library and go to Toronto Stock Exchange Review

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Value-Weighted SeriesA TSE Problem - when a
companys market capitalization gets too great

• This became a serious problem for the TSE 300
  Composite in 2000 since BCE (Bell Canada
  Enterprises) has a large number of shares
  outstanding and their the individual share price
  rose to a point where the firm and its
  subsidiaries represented more than 20 of the TSE
  300
• The reason this is a problem is that
  professionally-managed portfolios are not allowed
  to invest more than 10 of their value in any one
  stock (for proper diversification of riskand the
  need as a professional fiduciary to ensure proper
  diversification)hence, the usefulness of the TSE
  300 as a benchmark of comparison has diminished
  considerably.

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Unweighted Price Indicator Series

• In an unweighted index, all stocks carry equal
  weight regardless of their price or market value.
• A 20 stock is as important as a 40 stock, and
  the total market value of the company is
  unimportant.
• USE
• such an index can be used by individuals who
  randomly select stock for their portfolio and
  invest the same dollar amount in each stock.

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Unweighted Price Indicator Series ...

• The actual movements in the index are typically
  based on the arithmetic average of the percent
  changes in price or value for the stocks in the
  index.
• The use of the percent price changes means that
  the price level or the market value of the stock
  does not make a difference - each percentage
  change has equal weight.
• The arithmetic average of percent changes
  procedure is used in academic studies when the
  authors specify equal weighting.

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Example of an Arithmetic and Geometric Mean of
Percentage Changes

• Share Price
• Stock T T 1 HPR HPY
• X 10 12 1.20 0.20
• Y 22 20 0.91 -0.09
• Z 44 47 1.07 0.07
• II 1.20 0.91 1.07 sum 0.18
• 1.168 0.18/3 0.06
• 1.1681/3 1.0531 6
• Index Value (T) 1.0531 Index Value (T 1)
• Index Value (T) 1.06 Index Value (T 1)

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Unweighted Series ...

• Both Value Line and the Financial Times Ordinary
  Share Index compute a geometric mean of the
  holding period returns and derive the holding
  period yield from this calculation.

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Summary of Stock Market Indexes

• Number of
• Name of Index Weighting Stocks Source
• Dow Jones Industrial Average Price 30 NYSE
• Nikkei-Dow Jones Average Price 225 Tokyo
• SP 400 Industrial Market Value 400 NYSE, OTC
• SP Composite Market Value 500 NYSE, OTC
• NASDAQ Composite Market Value 4,879 OTC
• Wilshire 5000 Equity Value Market
  Value 5,000 NYSE, AMEX, OTC
• Russell 3,000 Market Value 3,000 NYSE, AMEX, OTC
• Value Line Industrial Average Equal
  (geo) 1,499 NYSE, AMEX, OTC
• TSE 300 Composite Market Value 300 TSE

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Bond-Market Indicator Series

• Investors know little about the several
  bond-market series because these bond series are
  relatively new and not widely published.
• Knowledge regarding these bond series is becoming
  more important because of the growth of
  fixed-income mutual funds and the consequent need
  to have a reliable set of benchmarks to use in
  evaluating performance.

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Bond-Market Indicator SeriesChallenges

• The creation and computation of bond-market
  indexes is more difficult than stock-market
  series for several reasons
• the universe of bonds is much broader than that
  of stocks, ranging from Federal Government bonds
  to bonds in default.
• The universe of bonds is constantly changing
  because numerous new issues, bonds maturing,
  calling of outstanding bonds, and bond sinking
  funds.
• The volatility of prices for individual bonds and
  bond portfolios change because bond price
  volatility is affected by duration, which is
  likewise constantly changing because of changes
  in maturity, coupon, and market yield.
• Pricing of bonds correctly especially in the case
  of corporates.

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Composite Stock-Bond Indexes

• A composite series is intended to measure the
  performance of all securities in a given country.
• Use of a composite series of stocks and bonds
  makes it possible to examine the benefits of
  diversifying with a combination of asset classes
  such as stocks and bonds in addition to
  diversifying within the asset classes of bonds or
  stocks.
• Examples
• Merrill Lynch - Wilshire U.S. Capital Markets
  Index
• Brinson Partners Global Security Market Index
  (GSMI) - this index contains both U.S. stocks and
  bonds, but also includes non-U.S. equities and
  nondollar bonds as well as an allocation to cash.

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Mean and Standard Deviation of Annual Percentage
Price Change for Stock Price Series 1972 - 1997

• Geometric Arithmetic Standard Coefficient
• Mean Mean Deviation of Variation
• DJIA 8.79 10.09 16.70 1.66
• SP 500 9.06 10.35 16.49 1.59
• NASDAQ 11.89 13.94 20.81 1.49
• Wilshire 5000 9.29 10.69 17.07 1.60
• TSE 300 11.32 12.54 16.52 1.32
• FT All-share 10.37 14.36 31.94 2.22
• Nikkei 6.97 9.74 25.77 2.65

This gives you an idea of the mean return and
volatility of returns for the universe of
securities measured by the respective index.
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Mean and Standard Deviation of Annual Rates of
Return for Lehman Brothers Bond Indexes 1972 -
1997

• Geometric Arithmetic Standard Coefficient
• Mean Mean Deviation of Variation
• Government/Corporate 9.68 9.95 8.04 0.81
• Government 9.65 9.77 7.15 0.73
• Corporate 10.17 10.60 10.25 0.97
• Mortgage-Backed 9.94 10.35 10.07 0.97

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Correlation Coefficients Among Monthly Percentage
Price Changes In Alternative Equity Indices 1972
- 1997

• SP NASDAQ Wilshire TSE
• 500 NYSE Composite 5000 300
• SP 500 -
• NYSE 0.919 -
• NASDAQ 0.783 0.881 -
• Wilshire 5000 0.906 0.987 0.906 -
• TSE 300 0.687 0.761 0.740 0.870 -
• Nikkei 0.358 0.350 0.308 0.335 0.293
• FT All-Share 0.615 0.712 0.620 0.693 0.627

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