Understanding Stock Market Averages

Investment Commentary March 1999 Copyright © 1999 Meyer Capital Management, Inc. All Rights Reserved.

March 31, 1999
DJIA: 9786.16
S&P 500: 1313.60
NASDAQ: 2461.40
Russell 2000: 397.63

1st Quarter Review
On a recent weeknight evening, my family was sitting around the dinner table discussing the day's events. As I contemplated a second helping of mashed potatoes, my wife Joan posed the following question. "Tim, I heard today that over a billion shares traded on the New York Stock Exchange, the Dow Jones Industrial Average (DJIA) set a new all-time high and advancing stocks outnumbered decliners by a four to three margin, yet the price of an average share actually declined. How can this be?"

Joan's question could be something of a metaphor for the first quarter and I'll share my response later in this report. While the MCM master portfolio performed strongly in January, outpacing all the major averages, the increasingly narrow stock participation across the equity markets dragged us back in February. March saw positive though unspectacular returns. The major market averages were similarly mixed. The DJIA and the S&P 500 Index were up strongly at +6.6% and +4.6%, respectively. Yet within the DJIA and the S&P 500, only a few stocks did well. How can this be?

As I've discussed in previous reports, the answer traces to the way in which the averages are calculated. As reported in the Wall Street Journal, the S&P 500's total year-to-date gain can be traced to only 21 stocks. The other 479 under performed the index. One third of the S&P's performance came from just two stocks, Microsoft and America Online! In the Dow Industrials, just three of its 30 component companies accounted for more than one half its gain. These were United Technologies, J. P. Morgan and American Express. Broader market measures like the Value Line Index, an average of 1700 stocks, fell -3.7% during the quarter, as did the Russell 2000 by -5.8%. These broader measures yield a more revealing view of the stock market's price activity.

The performance gap between the select few large cap high priced stocks driving the Dow Industrials & the S&P 500 and the rest of the market is exceptionally large. Some market historians argue that it is without precedent. Investing in the market movers is not a matter of stock picking prowess. The reality is that concentrating assets in these few stocks would be enormously risky. MCM holds a variety of the large-cap stocks that performed well during the quarter, but we also hold a broader selection of companies in order to keep overall portfolio risk within client guidelines.

One market commentator noted that since America Online was added to the S&P 500 last year, it appreciated so much in price that any money manager who didn't own it would, by definition, under perform the S&P 500 regardless of any other holdings. This is not hard to believe since America Online trades at more than 600 times trailing earnings and its market value is equal to that of Coca-Cola. eBay, the online-auction company, has a market value almost equal to Sears despite significantly lower sales and profits. To equal Sears, eBay would have to double its own sales and profits every year for the next 10 years, according to Ed Keon, director of quantitative research at Prudential Securities. This isn't impossible, but predicting the future 10 years out and betting money on it is, at best, an uncertain business.

The solution, in our view, is to avoid the temptation to chase market strength, hold to fundamentally sound investments, and wait for the market to turn convincingly in our direction. This is what happened, albeit fleetingly, in January. Since then the market has been signaling with increasing frequency that the narrowness of the big-cap rally is waning. One only has to look at the oil sector for example. Crude oil prices have recovered significantly from their lows of last year. So too have the stock prices of integrated oil stocks in general and oil service stocks like Schlumberger, Haliburton, Global Industries, and Nabors Industries, in particular.

Asian economies have stabilized and we believe the recovery will continue. This bodes well for technology companies like Atmel and Texas Instruments as well as big manufacturers like Boeing Co. We also continue to like our holdings in financial services, telecommunications, healthcare and toys.

Now, for the answer to Joan's question. The DJIA is comprised of only thirty of the New York Stock Exchange's 3,098 listed companies. Since this represents less than 1% of the companies traded on the big board, it does not fairly represent the broader market activity. Moreover, each listed company has a different number of outstanding shares of stock available for trading on any given day. Some have many millions of shares while others have fewer in number. When stocks with declining share prices trade a greater number of shares than those with increasing share prices, the average price per share will decline regardless of the number of companies advancing or declining. The magnitude of share price changes also figures into the result.

Bottom line, this illustrates how the major market averages can fool unsuspecting investors by disguising what is actually going on in the overall market. Now, can I have more mashed potatoes please?

Timothy R. Meyer
President