chapter 5 - security market indicator series

Saif [email protected]

[email protected]+923216633271

Lecture Presentation Software to accompany

Investment Analysis and Portfolio Management

Sixth Editionby

Frank K. Reilly & Keith C. Brown

Chapter 5

mailto:[email protected]

mailto:[email protected]

SAIF ULLAH, [email protected], +923216633271

Chapter 5Security-Market Indicator Series

Questions to be answered:

• What are some major uses of security-market indicator series (indexes)?

• What are the major characteristics that cause alternative indexes to differ?

• What are the major stock-market indexes in the United States and globally and what are their characteristics?


Chapter 5Security-Market Indicator Series

• What are the major bond-market indexes for the United States and the world?

• What are some of the composite stock-bond market indexes?

• Where can you get historical and current data for all these indexes?

• What is the short-run relationship among many of these indexes in the short run (monthly)?


Uses of Security-Market Indexes• Benchmark to judge portfolio

performance– (be sure to analyze differential risk)

• Develop an index portfolio– Index funds - match market performance

• Examine factors that influence aggregate security price movement


Uses of Security-Market Indexes

• Technicians believe past stock changes can be used to predict future price movement

• To compute systematic risk of an asset


Differentiating Factors in Constructing Market Indexes

The sample• size

• breadth

• source



Weighting sample members– price-weighted series

– value-weighted series

– unweighted (equally weighted) series



Computational procedure– arithmetic average

– indexed

– geometric average


Stock-Market Indicator Series

Dow Jones Industrial Average (DJIA)

NYSE Composite

S&P 500 Index

AMEX Index

Nikkei Average

and more….


Dow Jones Industrial Average (DJIA)

• Best-known, oldest, most popular series

• Price-weighted average of thirty large well-known industrial stocks, leaders in their industry, and listed on NYSE

• Total the current price of the 30 stocks and divide by a divisor (adjusted for stock splits and changes in the sample)


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)

Table 5.1


Demonstration of the Impact of Differently Priced Shares on a Price-Weighted

Indicator Series PERIOD T+ 1 .

Period T Case A Case B

A 100 110 100

B 50 50 50

C 30 30 33

Sum 180 190 183

Divisor 3 3 3

Average 60 63.3 61

Percentage Change 5.5% 1.7%

Table 5.2


Criticism of the DJIA• Sample used is limited

– 30 non-randomly selected blue-chip stocks are not representative of the 1800 NYSE listed stocks

• Price-weighted series– Stock split results in less weighting for sample

stock

– Introduces a downward bias in DJIA by reducing weighting of fastest growing companies whose stock splits


Nikkei-Dow Jones Average

• Arithmetic average of prices for 225 stocks on the First Section of the Tokyo Stock Exchange (TSE)

• Best-known series in Japan

• Price-weighted series formulated by Dow Jones and Company

• The 225 stocks represent 15 percent of all stocks on the First Section


Value-Weighted Series

• Derive the initial total market value of all stocks used in the seriesMarket Value = Number of Shares Outstanding

X Current Market Price

• Assign an beginning index value (100) and new market values are compared to the base index

• Automatic adjustment for splits

• Weighting depends on market value


Value-Weighted Series

where:

Indext = index value on day t

Pt = ending prices for stocks on day t

Qt = number of outstanding shares on day t

Pb = ending price for stocks on base day

Qb = number of outstanding shares on base day

ValueIndex BeginningIndex t

bb

tt

QP

QP


Unweighted Price Indicator Series

• All stocks carry equal weight regardless of price or market value

• May be used by individuals who randomly select stocks and invest the same dollar amount in each stock

• Some use arithmetic average of the percent price changes for the stocks in the index


Unweighted Price Indicator Series

• 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


Global Equity Indexes

• There are stock-market indexes available for most individual foreign markets

• These are closely followed within each country

• These are difficult to compare due to differences in sample selection, weighting, or computational procedure

• Groups have computed country indexes


FT/S&P-Actuaries World Indexes

• Jointly compiled by The Financial Times Limited, Goldman Sachs & Company, and Standard & Poor’s in conjunction with the Institute of Actuaries and the Faculty of Actuaries

• Measures 2,461 securities in 30 countries

• Covers 70% of the total value of all listed companies in each country



• Includes actively traded medium and small corporations along with major international equities

• Securities included must allow direct holdings of shares by foreign nationals

• Index is market-value weighted with a base date of December 31, 1986 = 100



• Index results are reported in U.S. dollars, U.K. pound sterling, Japanese yen, German mark, and the local currency of the country included

• Results are calculated daily after the New York markets close and published the following day in the Financial Times

• Geographic subgroups are also published


Morgan Stanley Capital International (MSCI) Indexes

• Three international, nineteen national, and thirty-eight international industry indexes

• Include 1,375 companies listed on stock exchanges in 19 countries with a combined capitalization representing 60 percent of the aggregate market value of the stock exchanges of these countries



• All the indexes are market-value weighted

• Reporting is in U.S. dollars and the country’s local currency

• Also provides– price to book value (P/BV) ratio– price to cash earnings (earnings plus depreciation)

(P/CE) ratio– price to earnings (P/E) ratio– dividend yield (YLD)



• The Morgan Stanley group index for Europe, Australia, and the Far East (EAFE) is used as the basis for futures and options contracts


Dow Jones World Stock Index

• Introduced in January 1993

• 2,200 companies worldwide

• Organized into 120 industry groups

• Includes 33 countries

• Countries are grouped into 3 regions


Dow Jones World Stock Index

• Represents over 80% of the combined capitalization of these countries

• Country indexes are computed in local currency, U.S. dollars, British pound, German mark, and Japanese yen


Comparison of World Stock Indexes

Correlations between the three series since December 31, 1991 indicate the results with the alternative world stock indexes are quite comparable

Table 5.9

U.S. DollarsFT - MS: .998FT - DJ: .997MS - DJ: .996


Bond-Market Indicator Series

• Relatively new and not widely published

• Growth in fixed-income mutual funds increase need for reliable benchmarks for evaluating performance

• Many managers have not matched aggregate bond market return– increasing interest in bond index funds– requires an index to emulate


Difficulties in Creating and Computing Bond-Market Indicator Series

• Range of bond quality varies from U.S. Treasury securities to bonds in default

• Bond market changes constantly with new issues, maturities, calls, and sinking funds

• Bond prices are affected by duration, which is dependent on maturity, coupon, and market yield

• Correctly pricing individual bond issues without current and continuous transaction prices available


Investment-Grade Bond Indexes

• Four investment firms maintain indexes for Treasury bonds and other investment grade (rated BBB or higher) bonds

• Relationship among these bonds is strong (correlations average 0.95)

• Returns for all these bonds are driven by aggregate interest rates - shifts in the government yield curve


High-Yield Bond Indexes

• Non investment-grade bonds– rated BB, B, CCC, CC, C

• Four investment firms and two academicians created indexes

• Relationship among alternative high-yield bond indexes is weaker than among investment grade indexes

• Merrill Lynch Convertible Securities Indexes


Global Government Bond Market Indexes

• Global bond market dominated by government issues

• Several indexes created by major investment firms– Measure total rates of return– Use market-value weighting– Use trader pricing– But sample sizes differ as do numbers of countries

included


Global Government Bond Market Indexes

• Differences affect long-term risk-return performance

• Low correlation among several countries is similar to stocks

• Significant exchange rate effect on volatility and correlations


Composite Stock-Bond Indexes

• Beyond separate stock indexes and bond indexes for individual countries, a natural step is a composite series that measures the performance of all securities in a given country

• This allows examination of benefits of diversification with a combination of asset classes such as stocks and bonds


Merrill Lynch-Wilshire U.S. Capital Markets Index (ML-WCMI)

• Market-value weighted index measures total return performance of the combined U.S. taxable fixed income and equity markets

• Combination of Merrill-Lynch fixed-income indexes and the Wilshire 5000 common-stock index

• Tracks over 10,000 stocks and bonds


Brinson Partners Global Security Market Index (GSMI)

• Includes:– U.S. stocks and bonds– Non-U.S. equities– Non-dollar bonds– Allocation to cash

• Matches a typical U.S. pension fund allocation policy

• Close to the theoretical “market portfolio of risky assets” referred to in CAPM


Comparison of Indexes Over Time

• Correlations among monthly equity price changes– Most differences are attributable to sample

differences– Different segments of U.S. stock market or from

different countries– Lower correlations between NYSE series and AMEX

series or NASDAQ index than between NYSE alternative series (S&P 500 and NYSE composite)


Correlation Coefficients Among Monthly Percentage Price Changes in Alternative Equity Market Indicator

Series: January 1972 (When Available) to December 1997Wilshire Toronto Tokyo FT M-S

S & P 500 5000 300 SE Nikkei FAZb All-SharebWorld

S & P 500 ___

0.919 ___

0.719 0.801 ___

0.783 0.881 0.824 ___

Wilshire 5000 0.906 0.987 0.817 0.906 ___

0.731 0.848 0.764 0.913 0.870 ___

Toronto 300 0.687 0.761 0.768 0.740 0.768 0.723 ___

Tokyo SE 0.302 0.299 0.245 0.251 0.284 0.249 0.269 ___

Nikkei 0.358 0.350 0.280 0.308 0.335 0.325 0.293 0.872 ___

FAZ 0.501 0.534 0.381 0.404 0.515 0.440 0.452 0.279 0.330 ___

FT All-Share 0.615 0.712 0.591 0.620 0.693 0.618 0.627 0.266 0.379 0.514 ___

M-S World 0.763 0.821 0.658 0.704 0.808 0.669 0.714 0.558 0.631 0.525 0.651 ___

0.590 0.695 0.508 0.589 0.666 0.572 0.616 0.664 0.731 0.505 0.617 0.960a Russell 2000 series starts in 1979b FAZ and FT All-Share series start in 1983

NYSE

AMEX

NASDAQ Ind.

c FT/S&P World Index series starts in 1986

NYSE AMEX Ind. 2000aNASDAQ Russell

FT/S&P World

Russell 2000

Table 5.11page 172

aRussell 2000 Series starts in 1979. bFAZ and FT All-Share series starts in 1983.cFT/S&P World Index series starts in 1986



• Correlations among monthly bond indexes– Among investment-grade bonds correlations

range from 0.90 to 0.99– Interest rates differ by risk premiums– Rates of return are determined by systematic

interest rate variables– Low correlation in global returns to U.S.

returns support global diversification



• Mean annual stock price changes– Expect differences among price changes and

measures of risk for various series due to the different samples

– NYSE series should have lower rates of return and risk measure than AMEX and OTC series

– Results generally confirm these expectations

– Canadian results had higher average returns than NYSE and lower risk than NASDAQ



• Mean annual stock price changes– United Kingdom (FT All-Share) had higher returns

than NYSE indexes, but much larger variability

– Japanese markets experienced lower returns and slightly lower volatility than the U.S. markets

– Japanese market shows low correlation with alternative U.S. stock-market indexes and could be a prime source of diversification



• Annual Bond Rates of Return– Total rates of return for bond-market indexes

cannot be directly compared to stock percentage price change results

– Expect difference in level of return due to differential risk premiums

– Results confirm expectations


The InternetInvestments Online

www.bloomberg.com

www.stockmaster.com

www.asx.com.au

www.bolsamadrid.es

www.tse.com

www.nikko.co.jp:80/SEC/index_e.html

www.exchange.de/realtime/dax_d.html

http://www.bloomberg.com/

http://www.stockmaster.com/

http://www.asx.com.au/

http://www.bolsamadrid.es/

http://www.tse.com/

www.nikko.co.jp:80/SEC/index_e.html

http://www.exchange.de/realtime/dax_d.html


End of Chapter 5–Security-Market Indicator Series


Future topicsChapter 6

• Sources of Information on Global Investments– Aggregate Economic Analysis

– Aggregate Security-Market Analysis

– Industry Analysis

– Individual Stock and Bond Analysis

– Mutual Funds

chapter 5 - security market indicator series

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