The Navigoe Blog

On the Nightly News, AKA Frames of Reference

Tune in to the business segment of the nightly news, or the front page of your local paper’s business section, and you will see the usual stock market report.  Most commonly, references to “the market” are specifically to the Dow Jones Industrial Average.
It’s the oldest and most recognized stock market index.  But, as I have previously commented, following an index that only tracks 30 stocks has major shortcomings. Most notable, thirty of the largest U.S. companies will not always move in a similar fashion to the rest of the world’s stocks. In those periods, whether it outperforms or underperforms, there will be a disconnect between the portfolio performance of most investors and what they expect by tuning in to the nightly news.

Of course, the stock market report on the news or your local paper do not only report on the Dow Jones Industrial Average (DJIA).  They typically also report the results of the S&P 500 index and the NASDAQ.  Surely, by reporting the results of three different indices, the news services are giving us a more complete picture of the global stock market results, right?  Unfortunately, no.

As a measuring stick, the S&P 500 still doesn’t allow most investors to intuitively understand the units of measure.  Is a daily increase of 35 points a large increase?  Most investors don’t really know the answer, despite knowing pretty well that it’s a modest one day move for the DJIA. Nonetheless, it has become the more popular benchmark against which to measure most investment returns.  This is party due to the fact that the S&P 500 measures a larger number of stocks; approximately 500 compared to 30 for the DJIA.  But does it really give us a broader picture of the overall market?  Not really.

The S&P 500 is a cap weighted index.  This means that while it tracks 500 stocks, the movement of the index is more heavily influenced by the largest companies than the smaller ones.  In fact, the top 50 companies of the S&P 500 make up close to 50% of the market capitalization of the index, rendering the bottom half or more of the stocks in the index irrelevant to the actual movement of the index.  As a result, the S&P 500 and the DJIA are correlated over 95% over the past 50 years.  In fact, out of the 30 stocks that make up the DJIA, 24 of them are among the 50 largest companies in the S&P 500.

But isn’t there another index in the nightly news?  Sure, it’s the NASDAQ.  I gotta be honest.  I’m baffled by the inclusion of the NASDAQ in the nightly news business report.  Like the DJIA and the S&P 500, it primarily measures large U.S. growth companies.  So, it provides little by way of diversified reporting.  In fact, the NASDAQ is a technology heavy index, effectively making it a sector index, which makes its inclusion as one of the major indices for the nightly news to report on even more odd.  I wouldn’t expect an index of healthcare, energy, or transportation stocks to be included in the business report’s comprehensive coverage of three indices. So, why is a technology heavy index?

In fact, other than the technology heavy weightings, the NASDAQ is also highly correlated with the S&P 500.  Eleven of the 15 largest companies in the NASDAQ are among the aforementioned S&P 500 50 largest companies. I have a theory that the NASDAQ first became closely watched during the late 90s when tech stocks were dominating the stock reports. Business news reached all time peaks for viewership/readership, and demand for tech stock news was high.  Even after the dot-com bubble burst, interest in these stocks remained high. Even today, tech stocks like Apple, Google, and Microsoft continue to dominate business news. Despite the high interest, it’s a terrible index for benchmark purposes.

Most significant in looking at the three stock market indices reported in the nightly news, is the exclusion of international, emerging markets, value, and  small cap stocks. In fact, all of the indices reported upon are large cap U.S. growth indices. This leads to skewed frames of reference.

Most smart investors do not intentionally have highly concentrated portfolios. Most well constructed portfolios consist of diversified holdings, including asset classes not represented by the nightly news’ indices.  The intention behind such a diversified portfolio is to reduce overall risk of being heavily invested in a single asset class that has a poorly performing period such as the devastating performance of U.S. large growth (especially tech stocks) in the 2000-02 tech stock crash. Or, more recently, both the Euro currency and the stocks of its constituent countries declined in 2011.

Investors who choose to implement diversified portfolios understand that the market by doing so, certain segments of their portfolio will outperform at times, meaning that other segments will underperform. Over time, this will likely rotate meaning that the asset classes that underperformed might outperform another time.

The problem is with the nightly news. It becomes the yardstick, despite its limitations in measuring only one segment of the market. When U.S. large growth stocks are middle of the pack performers or bringing up the rear, diversified portfolios look like brilliant investment strategies. However, during periods when U.S. large growth stocks are outperforming all other asset classes, as was the case in the late 1990s, diversified portfolios look like dumb investment strategies.

The reality is that neither is true. Diversified portfolios are neither brilliant nor dumb. They are prudent investment strategies that happen to look different from the nightly news.