What moves the Dow and S&P500?

Charlie Munger, Warren Buffet’s partner and a font of great sayings himself, has said about investing that, “It’s not supposed to be easy. Anyone who finds it easy is stupid.” Based on the year-to-date results in this market, I don’t think there’s many investors of any type who are stupid cuz it sure hasn’t been easy.

According to the S&P folks, with only a few exceptions, our main market index has spent the year trading between 2040 and 2130. This is one of the narrowest ranges in market history. The Dow has had much the same result with that Index moving to the negative for the year last Thursday. That made the 21st time the Index has moved either side of unchanged for the year. Bespoke Investment Group said that’s the most for any market in history…

All this simply reinforces that we’re in a transition period; moving from 30-plus years of, basically, declining interest rates into one where they will be rising over time. Add to that the usual mix of uncertainties and you get a headline-sensitive market with lots of smoke (and hot air) and very little fire or substance.

That was seen this past week with the release of second quarter earnings from about 25% of the S&P500 companies…75 percent of those companies beat estimates and you’d never realize that by the way the market reacted. While the net result, as stated above, has been negligible, day-to-day for the stocks in question – and the movement of those indices – can be exciting…in all senses of that term.

What moves the Dow?

So, Mike, if there is as you contend that there’s very little net movement, how come the Dow can flip around so much on a daily basis? I get this a lot from folks, so let me try to give you some idea why that can happen.

The Dow Industrial Index is made up of just 30 companies. Additionally, it’s what’s called a price-weighted index. That means that those companies that are the most highly priced in the Dow will exert an influence on the Index value well above that of those at the low end of the price scale. That’s point one.

Point two is something called the divisor. There’s a big, long formula to compute this but, bottom line, it’s a way to sort of level the effect of such a wide range of changing stock prices. The actual number is 6.67. That means that for each one point daily move in any of the 30 Dow stocks, there will be a 6.67 point move in the Dow. And that’s up or down.

For example, what the price-weighting does was visibly demonstrated last week when 3M, Caterpillar (CAT), IBM and United Technologies (UTX) all reported earnings. On Tuesday, when IBM and UTX reported earnings the traders didn’t like, those stocks sold off, with IBM and UTX dropping by 5.9% and 7.0%, respectively. The Dow ended 180 points lower that day, with just those two stocks having contributed a total of 106 of those down points.

So, last week, when 3M and CAT reported their numbers, the Dow ended lower by 119 points that day. About 58 of those points were due to the lower prices in just these shares.

Because of its share price, Apple has 5 times the effect on the Dow than either GE or Cisco Systems currently has, due to their share prices.

What about the S&P500?

This Index, in addition to having “just a few more” companies within it, differs from the Dow in that it’s what’s known as a market-weighted index. In this case, the companies with the biggest total value, known as market capitalization, aka, market cap, will have the biggest effect on the Index each day.

Apple is currently, by far, the largest company in the world. Its market cap is about $720Billion; the number 2 company by market cap is ExxonMobil. It has “only” around $360Billion in market cap. (Both are also members of the Dow Industrials.) So, when Apple reported its earnings earlier last week, the S&P was down 0.23 points for the day. Apple was the reason for around 0.18 of those points and about 50 of the Dow points lost that same day.

Conclusion

I hope you have a better understanding now of why the Dow is a tough index to use to tell you how the overall market is doing. Unless you choose to check the action the companies within the Dow 30, you may not realize that what seemed like a particularly good or bad market day may have simply been due to the fortunes of just one or two companies. I hope too that you better understand how, due to that effect, one day doesn’t hardly ever translate into a trend.

As I said earlier, investing is very challenging, even for the most experienced professionals. I firmly believe that the best long-term investors understand that the never-ending geopolitical, Fed policy and current economic challenge headlines are absolutely meaningless over the long run.

However, most media outlets, blogs, newspapers, and radio shows make money by peddling fear, using current economic and/or political concerns to jump from one crisis du jour to another. If you react to the headlines about Greece, China, Fed policy, etc., regarding your investing, you’re also likely going to be costing yourself a lot of money.

Sure, stocks will go down by a significant amount eventually – they always do. Stocks can temporarily go down based on the fear du jour, like the 10-20% corrections we saw in 2010, 2011, 2012, and 2014. The nastiest hits to stock markets always come from good old-fashioned cyclical recessions. As I’ve talked about before, there are no signs of a recession on the horizon. Until then, the bears continue to fight an uphill battle.

Morgan Stanley chief US equity strategist Adam Parker doesn’t even want to acknowledge the doomsayers right now, even with stocks near all-time highs. Nor does Parker think these folks deserve credit when we finally get a stock-market correction.

“We all know lots of people who have called 17 of the last zero corrections,” Parker wrote in a note to clients last Monday. “We aren’t inclined to give them credit when they are finally right.”

“Most of us would’ve been banished from the money management industry by 2000 if we were bearish the whole way up on [technology, media, and telecom] valuations.” In the end, Parker said he didn’t see a major market correction coming anytime soon (a fine case of great minds working together) and he was loath to call a top where he didn’t see one forming.

Therefore, Parker remains bullish on US stocks. Parker’s year–end S&P 500 forecast is 2,275, or close to another 10% gain from here.

While we know that there are no guarantees that his prediction will come true, nonetheless I’m with him, for sure…

Cheers!

Mike
Securities and Investment Advisory Services offered through KMS Financial Services, Inc.
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