Tabell’s Market Letter – May 13, 1977

, . — — – – j TABELL'S ! MARKET LETTER 1 JI 909 STATE ROAD, PRINCETON, NEW JERSEY 081540 DIVISION OF MEMBER NEW VORK STOCK EXCHANGE, INC MEMBER AMERICAN STOCK eXCHANGE May 13, 1977 We began last week a discourse 9n the composition of some of the more widely-followed – market.verIges withthe npte ,that wein!el1d9.1o,;c.optinue. hisdiscuss ion,in future-1etters. Our.;;.. …- 1–work with averages at this time is motivated by a bit more than the Simple desire to fill up space in a rather dull stock market. As readers will be aware, there has been growing interest of late in a technique called indexing. This latest of panaceas to gain a following among professional money managers involves the construction of a portfolio so as to duplicate, as precisely as possible, the performance of a given market average — in most cases, the S & P 500. We will have some thoughts on this subject before we are done. Before discussing the concept, however, it is worthwhile to have some idea of the criteria used to index a portfolio. Hence, some further discussion of the two most popular indicators, the Dow-Jones 30 Industrials and the S & P SOD-Stock Index. The anomalies in the Dow have been pointed out by many writers. They start out with the fact that the average sells for over 900 despite the fact that no one of the 30 components sells for anywhere near that price. This stems from the method used to adjust for splits, additions and deletions since the average was first put together in its present form in 1928. The computation of the average simply consists of adding up the closing prices of the 30 indiVidual issues and dividing by a constant divisor. When a split or other adjustment takes place, it is that divisor which is changed, not the process of cumulating the prices of one share of each stock. After almost 50 years of adjustment, the divisor is now 1.474, thus producing the current high level of the average. Strangely enough, it is not the divisor itself but the technique of using the price of just one share of each stock which causes the distortion in the index. The method causes high-priced stocks to be weighted more heavily than low-priced ones. Thus, Dupont accounts for 9 of the Dow Simply by virtue of its currently having the highest price while Chrysler is the least lmportant component by reasOnof b-elnc;i tlierowest'-pficed'iSStfE;7'WeteDuP6Iit to spliCterlforone-; it wOulalmmediatel'Y' change from the most important factor in the index to the least important one by a considerable margin. Most portfolios, obviously, are constructed around equal market value holdings of all component stocks, certainly not on the basis of an equal number of shares. Yet, it is precisely this basis on which the Dow is put together. The need for a broader and more scientific index led to the origination, over 20 years ago, of the S & P 500. Paradoxically, the S & P, despite its 500 components, is not a broad index at all. The reason for this, again, lies in the details of computation. The method essentially is to take the price of each of the components and multiply it by the total number of shares outstanding. The resultant total market value is then diVided by a base — originally calculated to make the index equal to 10 in a 1941-43 base period. The result is, to paraphrase George Orwell, that some stocks wind up being a great deal more equal than others,and the larger companies bear a disproportionate weight in the index. The table below illustrates the phenomenon. With this capital-weighting, IBM and American Telephone between then account for the same weight in the index as the 283 lowest-ranked companies. 1st 2 stocks 1st 4 stocks 1st 11 stocks 1st 22 stocks —1st 37 stocks Weight in 500 Weight in 500 13 Lowest 100 stocks 1.4 20 Lowest 200 stocks 5.8 30 Lowest 300 stocks 14.8 40 Lowest 400 stocks 30.0 -. – -50—-' -Lowest.,450 stocks-'-'-43-6 — –.- The above remarks sound more critical of the two market indicators than they are, in fact, meant to be. They are meant only to point out the fact that both indicators have limitations for statistical purposes, and it is best to be aware of these limitations before proceeding further, let alone measuring portfolio performance on the action of these averages. The fact is, quite simply, that there is no such thing as a perfect market average nor will there ever be. The appropriateness of a given average is solely dependent on the use to which it is being put. Whether a given index is an adequate measure of portfolio performance will depend, moreover, on the characteristics of the portfolio for which it is used as a benchmark. This is a point to which we intend to return in future discussion. Dow- Jones Industrials (12 00 p. m.) S&P CompOSite (1200 p.m.) Cumulative Index (5/11/77) AWT/jb 927.49 98.88 662.66 ANTHONY W. TABELL DELAFIELD, HARVEY, TABELL No statement or expreSlon of opinion or ony other matter herein conlolned IS, or IS 10 be deemed to be, directly or IndHectly, on offer or the Ol,cltollon of on offer 10 buy or sell ony securrty referred 10 or mentioned The motler 15 presented merely for The convel'tence of The subscriber While -He believe Ihe sources of our information 10 be reliable, we In no way represent or guarantee Ihe accuracy thereof nor of the statemenTS mude herein Any action to be laken by the subSCriber should be based on hiS own Investigation and 'nformatIon Janney Montgomery SCali. 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