Understanding Market Indexes

Index investing often is called passive investing, but it is far from passive.

An index is not “the market,” as many people believe. Instead, people construct the indexes.

Sometimes the index creators are trying to develop a subset of stocks that they believe best reflects the total market. Other times they’re trying to develop an index that will earn higher returns than other indexes.

The composition of an index changes over time. Some of the changes are due to corporate actions, such as mergers and bankruptcies. Other times the people in charge of the index add and subtract stocks to improve the index or better reflect the market.

The indexes also change with the market and economy. Some stocks and industries grow faster than others, and thereby change their weight in the index.

Bespoke Investment Group recently posted some charts showing how the sector composition of the S&P 500 changed over the decades.

For example, back in 1990 the different sectors were fairly evenly weighted in the index, with Industrials being the dominant sector at 14.72% of the index. Since then, sharp differences in the performances of different sectors have produced wide variations in the index weightings.

Technology ranged from a low of about 7% in 1990 to a high of greater than 35% in 2000 to today’s index-leading level of 23%. Energy also has been on a roller-coaster ride. It hit highs of more than 15% in 1990 and 2009. But today energy is only 5.80% of the S&P 500. The link presents these and other changes a couple of different ways.

When you invest in the S&P 500 today, more than half of your money is invested in technology, financials and health care.

Bespoke also published some tables showing how the size and weightings of the largest stocks changed over the last 10 years. It is eye-opening for many investors.

In a few years, the weightings might be very different. The history of the index has been that when a sector’s weighting increases substantially over time, it hits a peak and is likely to enter a bear market. That’s the nature of a capitalization-weighted index such as the S&P 500. The better a sector’s stocks perform relative to others, the greater the sector’s weighting in the index. More and more money flows into that sector as investors add to index funds.

Eventually, active investors begin selling their holdings in the sector because it appears overvalued or earnings fail to meet expectations. In the past, that’s been enough to slow the sector’s momentum and lead to its decline. We’ve seen the cycle with technology, energy and financials. It also has applied to many individual stocks.

I’m not saying index funds are a bad investment. I’m saying that before investing in an index, investors should understand how an index changes over time and what causes the changes.

The Data

Most of the last week’s economic reports were positive surprises, surpassing expectations.

Retail sales were the biggest surprise. They increased 0.6%. Also, last month’s decline of 0.2% was revised to an increase of 0.3%. Excluding autos and gas, retail sales still increased 0.5%.

This shows how volatile retail sales are and the importance of not reading too much into one or two months of retail sales data. In recent months, retail sales have been less than expectations and caused analysts to raise alarms about the economy. It is better to look at sales over three to six months than rely on a one-month snapshot.

The Empire State Manufacturing Survey jumped from 9.8 to 25.2. This is the highest reading since September 2014 and one of the highest readings of this recovery. The survey was strong at the start of 2017 but stumbled in April and May, actually delivering a negative number in May. But it bounced back strongly and indicates that, after a pause, manufacturing continues its recovery.

The Philadelphia Fed Business Outlook Survey also was a strong 18.9, exceeding expectations and dipping only a little from last month’s 19.5. The index still is below historic highs it reached earlier this year, but many components of the index are at or near the 35-year highs.

Actual government manufacturing data, however, still isn’t matching these anecdotal surveys. Industrial Production increased only 0.2% for the month, and the manufacturing component declined 0.2%. The data are skewed some by the recent decline in automobiles production, which now has declined three consecutive months. Excluding vehicles, manufacturing increased 0.2%. Businesses, however, still aren’t spending to expand. Business equipment production declined 0.5% for the month.

Home builders also are becoming more positive. The Housing Market Index from NAHB faded the last few months but jumped this month to 68 from 64. This puts it near the recovery high of 71 reported in February. The weakness in the report continues to be a lack of first-time home buyers.

Housing starts were weak in the headline number, but the report wasn’t bad across the board. After recovering to a 1.2 million annual rate last month, housing starts fell near the recent lows of March and April. The good news is most of the decline was in multi-family housing. Starts of single-family homes are up 11% over 12 months to show a healthy contribution to economic growth.

The index of Leading Economic Indicators from the Conference Board rose 0.3%, down a little from last month’s strong 0.6%, but still indicating continued growth in the economy for the next six months.

Inflation remains low. It increased only 0.1% for the month in both the headline number of the Consumer Price Index and after excluding food and energy. Both measures also increased 1.7% over 12 months.

New unemployment claims declined a hefty 12,000, bringing them very close to the historic low reached in February.

The Markets

The S&P 500 declined again. This time is was down 0.14% for the week ended with Wednesday’s close. The Dow Jones Industrial Average was unchanged for the week. The Russell 2000 fell 0.92%. The All-Country World Index declined 0.36%. Emerging market equities decreased 0.77%.

Long-term treasuries rose 0.35%. Investment-grade bonds rose 0.21%. Treasury Inflation-Protected Securities (TIPS) declined 0.27%. High-yield bonds fell 0.15%.

The dollar rose another 0.02%.

Energy-based commodities reversed recent gains, declining 3.31% for the week. Broader-based commodities fell 2.48%. Gold gained 0.16%.

Bob’s News & Updates

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