Stock market indicators have come to perform a variety of functions, from serving as benchmarks for evaluating the performance of professional money managers to answering the question, “How did the mar- ket do today?” Thus, stock market indicators (indexes or averages) have become a part of everyday life. Even though many of the stock market indicators are used interchangeably, it is important to realize that each indicator applies to, and measures, a different facet of the stock market.
The most commonly quoted stock market indicator is the Dow Jones Industrial Average (DJIA). Other popular stock market indicators cited in the financial press are the Standard & Poor’s 500 Composite (S&P 500), the New York Stock Exchange Composite Index (NYSE Composite), the NASDAQ Composite Index, and the Value Line Composite Average (VLCA). There are a myriad of other stock market indicators such as the Wilshire stock indexes and the Russell stock indexes, which are followed primarily by institutional money managers.
In general, market indexes rise and fall in fairly similar patterns. Although the correlations among indexes are high, the indexes do not move in exactly the same way at all times. The differences in movement reflect the different manner in which the indexes are constructed. Three factors enter into that construction: the universe of stocks represented by the sample underlying the index, the relative weights assigned to the stocks included in the index, and the method of averaging across all the stocks.
Some indexes represent only stocks listed on an exchange. Examples are the DJIA and the NYSE Composite, which represent only stocks listed on the NYSE or Big Board. By contrast, the NASDAQ includes only stocks traded over the counter. A favorite of professionals is the S&P 500 because it is a broader index containing both NYSE-listed and OTC-traded shares. Each index relies on a sample of stocks from its universe, and that sample may be small or quite large. The DJIA uses only 30 of the NYSE-traded shares, while the NYSE Composite includes every one of the listed shares. The NASDAQ also includes all shares in its universe, while the S&P 500 has a sample that contains only 500 of the more than 8,000 shares in the universe it represents.
The stocks included in a stock market index must be combined in certain proportions, and each stock must be given a weight. The three main approaches to weighting are: (1) weighting by the market capitalization, which is the value of the number of shares times price per share; (2) weighting by the price of the stock; and (3) equal weighting for each stock, regardless of its price or its firm’s market value. With the exception of the Dow Jones averages (such as the DJIA) and the VLCA, nearly all of the most widely used indexes are market-value weighted. The DJIA is a price-weighted average, and the VLCA is an equally weighted index.
Stock market indicators can be classified into three groups: (1) those produced by stock exchanges based on all stocks traded on the exchanges; (2) those produced by organizations that subjectively select the stocks to be included in indexes; and (3) those where stock selection is based on an objective measure, such as the market capitalization of the company. The first group includes the New York Stock Exchange Composite Index, which reflects the market value of all stocks traded on the NYSE. While it is not an exchange, the NASDAQ Composite Index falls into this category because the index represents all stocks traded on the NASDAQ system.
Posts Tagged ‘loans’
Stock Market Indicators, part 1
November 16th, 2010Summary of required rate of return
November 16th, 2010The overall required rate of return on alternative investments is determined by three variables: (1) the economy’s RRFR, which is influenced by the investment opportunities in the economy (that is, the long-run real growth rate); (2) variables that influence the NRFR, which include short-run ease or tightness in the capital market and the expected rate of inflation (notably, these variables, which determine the NRFR, are the same for all investments); and (3) the risk premium on the investment. In turn, this risk premium can be related to fundamental factors, including business risk, financial risk, liquidity risk, exchange rate risk, and country risk, or it can be a function of systematic market risk (beta).
Measures and Sources of Risk We have examined both measures and sources of risk arising from an investment. The measures of risk for an investment are:
? Variance of rates of return
? Standard deviation of rates of return
? Coefficient of variation of rates of return (standard deviation/means)
? Covariance of returns with the market portfolio (beta)
The sources of risk are:
? Business risk
? Financial risk
? Liquidity risk
? Exchange rate risk
? Country risk
Market Capitalization
November 16th, 2010Market capitalization is defined as the total dollar value of a stock’s out- standing shares and is computed by multiplying the number of outstanding shares by the current market price. Thus, market capitalization is a measure of corporate size. With approximately 8,500 stocks available to trade on U.S. stock exchanges, many traders judge a company by its size, which can be a determinant in price and risk. In fact, there are four unofficial size classifications for U.S. stocks: blue chips, mid-caps, small caps, and micro-caps.
1. Blue-chip stocks. Blue chip is a term derived from poker, where blue chips in a card game hold the most value. Hence, blue-chip stocks are those stocks that have the most market capitalization in the market- place (more than $5 billion). Typically they enjoy solid value and good security, with a record of continuous dividend payments and other desirable investment attributes.
2. Mid-cap stocks. Mid-caps usually have a bigger growth potential than blue-chip stocks but they are not as heavily capitalized ($500 million to $5 billion).
3. Small-cap stocks. Small caps can be potentially difficult to trade be- cause they do not have the benefit of high liquidity (valued at $150 million to $500 million). However, these stocks, although quite risky, are usually relatively inexpensive and big gains are possible.
4. Micro-cap stocks. Micro-caps, also known as penny stocks, are stocks priced at less than $2 per share with a market capitalization of less than $150 million.
Some traders like to trade riskier stocks because they have the potential for big price moves; others prefer the longer-term stability of blue-chip stocks. In general, deciding which stocks to trade depends on your time availability, stress threshold, and account size.
Credit spreads
November 9th, 2009The use of duration as a measure of interest rate risk implicitly assumes that there is no relationship between credit spreads and the level of risk-free rates. In fact it ignores credit spreads completely. In a stable interest rate environment, but where credit spreads are widening, the use of duration as a measure of changing economic value will tend to overstate the value of a bank’s assets and hence its economic value.
Beware of the secondary effects: Economic actions often generate indirect as well as direct effects
July 7th, 2009In addition to direct effects that are quickly visible, people’s decisions often generate indirect, or “secondary,” effects that may be observable only with time. Failure to consider secondary effects is one of the most common economic errors because these effects are often quite different from initial, or direct, effects. Frederic Bastiat, a nineteenth-century French economist, stated that the difference between a good and a bad economist is that the bad economist considers only the immediate, visible effects.
The true cause of these secondary effects might not be seen, even later, except by those using the logic of good economics.
Perhaps a few simple examples that involve both immediate (direct) and secondary (indirect) effects will help illustrate the point. The immediate effect of an aspirin is a bitter taste in one’s mouth. The secondary effect, which is not immediately observable, is relief from a headache. The short-term direct effect of drinking twelve cans of beer might be a warm, jolly feeling. In contrast, the secondary effect is likely to be a sluggish feeling the next morning, and perhaps a pounding headache.
Sometimes, as in the case of the aspirin, the secondary effect-headache relief-is actually an intended consequence of the action. In other cases, however, the secondary effects are unintended. Changes in government policy often alter incentives, indirectly affecting how much people work, earn, invest, consume, and conserve for the future. When a change alters incentives, unintended consequences that are quite different from the intended consequences may occur.
Let’s consider a couple of examples that illustrate the potential importance of unin- tended side effects. In an effort to reduce gasoline consumption, the federal government mandates that automobiles be more fuel efficient. Is this regulation a sound policy? It may be, but when evaluating the policy’s overall impact, one should not overlook its secondary effects. To achieve the higher fuel efficiency, auto manufacturers will reduce the size and weight of vehicles. As a result, there will be more highway deaths-about 2,000 more per year-than would otherwise occur because these lighter cars do not offer as much protec- tion for occupants. Furthermore, because the higher mileage standards for cars and light trucks make driving cheaper, people tend to drive more than they otherwise would. Thi increases congestion and results in a smaller reduction in gasoline consumption than was intended by the regulation. Once you consider the secondary effects, the fuel efficiency regulations are much less beneficial than they might first appear.
Trade restrictions between nations have important secondary effects as well. The proponents of tariffs and quotas on foreign goods almost always ignore the secondary effects of their policies. Import quotas restricting the sale of foreign-produced sugar in the U.S. market, for example, have led to sugar prices that are about three times what they are in the rest of the world. The proponents of this policy-primarily sugar producers-argue that the quotas “save jobs” and increase employment. No doubt, the employment of sugar growers in the United States is higher than it otherwise would be. But what about the secondary effects? The higher sugar prices mean it’s more expensive for U.S. firms to produce candy and other products that use a lot of sugar. As a result, many candy producers, including the makers of Life Savers, Jaw Breakers, Red Hots, and Fannie May and Fanny Farmer chocolates, have moved to countries like Canada and Mexico, where sugar can be purchased at its true market price. Thus, employment among sugar-using firms in the United States is reduced. Further, because foreigners sell less sugar in the United States, they have less purchasing power with which to buy products we export to them. This, too, reduces U.S. employment. Once the secondary effects of trade restrictions like the sugar quota program are taken into consideration, we have no reason to expect that U.S. employment will increase as a result. There may be more jobs in favored industries, but there will be less employment in others. Trade restrictions reshuffle employment rather than increase it. But those who unwittingly fail to consider the secondary effects will miss this point. Clearly, consideration of the secondary effects is an important ingredient of the economic way of thinking.
The use of scarce resources is costly, so trade-offs must be made.
July 2nd, 2009Economists sometimes refer to this as the “there is no such thing as a free lunch” principle. Because resources are scarce, the use of resources to produce one good diverts those resources from the production of other goods. A parcel of undeveloped land could be used for a new hospital or a parking lot, or it could simply be left undeveloped. No option is free of cost-there is always a trade-off. The choice to pursue any one of these options means the others must be sacrificed. The highest valued alternative that must be sacrificed is the opportunity cost of the option chosen. For example, if you use one hour of your scarce time to study economics, you will have one hour less time to watch television, read magazines, sleep, work at a job, or study other subjects. Whichever one of these options you would have chosen had you not spent the hour studying economics is your highest valued option forgone. If you would have been sleeping, then the opportunity cost of this hour spent studying economics is a forgone hour of sleep. In economics, the opportunity cost of an action is the highest valued option given up when a choice is made.
It is important to recognize that the use of scarce resources to produce a good is always costly, regardless of who pays for the good or service produced. In many countries, various kinds of schooling are provided free of charge to students. However, provision of the schooling is not free to the community as a whole. The scarce resources used to produce the schooling-to construct the building, hire teachers, buy equipment, and so on-could have been used instead to produce more recreation, entertainment, housing, medical care, or other goods. The opportunity cost of the schooling is the highest valued option given up because the resources required for its production were instead used for schooling.
By now the central point should be obvious. As we make choices, we are continually faced with trade-offs. Using resources to do one thing leaves fewer resources to do another. Consider one final example. Mandatory air bags in automobiles save an estimated 400 lives each year. Economic thinking, however, forces us to ask ourselves if the $SO billion spent on air bags could have been used in a better way-perhaps say, for cancer research that could have saved more than 400 lives per year. Most people don’t like to think of air bags and cancer research as an “eitherlor” proposition. It’s more convenient to ignore these trade-offs. But if we want to get the most out of our resources, we have to consider all of our alternatives. In this case, the appropriate analysis is not lives saved with air bags versus dollars spent on them, but the number of lives that could have been saved (or other things that could have been accomplished) if the $SO billion had been used differently. A candid consideration of hard trade-offs like this is essential to using our resources wisely.