This column was supplied by Ben Craig, Financial Advisor at Raymond James. Ltd.
You've likely read the news by now. U.S. markets hit record highs recently, as both the Dow Jones Industrial Average (the Dow) and the S&P500 (S&P) surpassed heights last reached in 2007. This news will make headlines for the foreseeable future, so perhaps it's time to take a closer look at these global benchmarks to assess their relevance as barometers of the economic situation.
First, neither of these indexes adjusts for inflation. It's important to adjust for inflation. You may have heard that the median wage is roughly the same as it was 15 years ago. If you didn't adjust for inflation, you would say the median wage has risen by more than 40 percent over the past 15 years. But that would be a meaningless statement. When buying power is factored in, the Dow, currently trading around 14,600, was higher in the year 2000, and also 2007. Second, there are issues with the way the Dow is calculated. Basically, a small committee selects 30 big companies, and then adds up the price of their stocks. Analysts divide that number by a Divisor, resulting in a figure repeated throughout the world. The Dow is a price weighted index. That means higher priced Dow stocks have more impact on the index level than their lower priced peers. Consider IBM trading at $213 and Alcoa trading at $9. If both companies' stock prices move up 2% over the day, IBM will have a much greater impact on the level of the Dow than Alcoa.
The S&P500 soon followed the Dow's rise with its own record on March 28. This index is a more accurate gauge for two reasons. First, the index contains 500 companies vs. 30 in the Dow, which provides a broader view of business conditions in America. Second the S&P is market cap weighted. Market Cap, (or capitalization) reflects the size of a given company by taking its shares outstanding and multiplying the number by the price of those shares. In such a scheme, the stock price movements of larger companies have a greater impact on the index levels.
Ben Craig, Financial Advisor at Raymond James Ltd. can be reached at 604-882-1260 or via email at [email protected] Ben is a coquitlam resident and has been helping clients reach their goals for over ten years.
