- I have spent much of last week doing interviews on what the push to all-time highs means. In reality, for most individuals, it means very little. That is the crux of this week’s missive which is the disconnect that exists between portfolio performance and index performance.
Building The Sample Index
“The S&P 500 is a U.S. market index that is computed by a weighted average market capitalization. The first step in this methodology is to compute the market capitalization of each component in the index.This is done by taking the number of outstanding shares of each company and multiplying that number by the company's current share price, or market value. For example, if Apple Computer has roughly 830 million shares outstanding and its current market price is $53.55, the market capitalization for the company is $44.45 billion (830 million x $53.55).Next, the market capitalizations for all 500 component stocks are summed to obtain the total market capitalization of the S&P 500, as illustrated in the table below. This market capitalization number will fluctuate as the underlying share prices and outstanding share numbers change.
In order to understand how the underlying stocks affect the index, the market weight (index weight) needs to be calculated. This is done by dividing the market capitalization of a company on the index by the total market capitalization of the index.For example, if Exxon Mobil's market cap is $367.05 billion and the S&P 500 market cap is $10.64 trillion, this gives Exxon a market weight of roughly 3.45% ($367.05 billion / $10.64 trillion). The larger the market weight of a company, the more impact each 1% change will have on the index.For example, if Exxon Mobil were to rise by 20% while all other companies remained unchanged, the S&P 500 would increase in value by 0.6899% (3.45% x 20%). If a similar situation were to happen to The New York Times, it would cause a much smaller, 0.0076% change to the index because of the company's smaller market weight.”
The Status Quo
Share Buybacks & Bankruptcy
- Company DEF buys back 50% of their outstanding shares
- Company MNO files for bankruptcy.
- Each company experiences a change in share price.
The Replacement Effect
What About Performance?
“Comparison is the cause of more unhappiness in the world than anything else. Perhaps it is inevitable that human beings as social animals have an urge to compare themselves with one another. Maybe it is just because we are all terminally insecure in some cosmic sense. Social comparison comes in many different guises. ‘Keeping up with the Joneses,’ is one well-known way.If your boss gave you a Mercedes as a yearly bonus, you would be thrilled—right up until you found out everyone else in the office got two cars. Then you are ticked. But really, are you deprived for getting a Mercedes? Isn't that enough?Comparison-created unhappiness and insecurity is pervasive, judging from the amount of spam touting various enlargement procedures for males and females. The basic principle seems to be that whatever we have is enough, until we see someone else who has more. Whatever the reason, comparison in financial markets can lead to remarkably bad decisions.Comparison in the financial arena is the main reason clients have trouble patiently sitting on their hands, letting whatever process they are comfortable with work for them. They get waylaid by some comparison along the way and lose their focus. If you tell a client that they made 12% on their account, they are very pleased. If you subsequently inform them that 'everyone else' made 14%, you have made them upset. The whole financial services industry, as it is constructed now, is predicated on making people upset so they will move their money around in a frenzy. Money in motion creates fees and commissions. The creation of more and more benchmarks and style boxes is nothing more than the creation of more things to COMPARE to, allowing clients to stay in a perpetual state of outrage.”
1) The index contains no cash2) It has no life expectancy requirements - but you do.3) It does not have to compensate for distributions to meet living requirements - but you do.4) It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance - this is fine on the way up, but not on the way down.5) It has no taxes, costs or other expenses associated with it - but you do.6) It has the ability to substitute at no penalty – but you don’t.7) It benefits from share buybacks – but you don’t.
"Suppressed wage growth, layoffs, cost-cutting, productivity increases, accounting gimmickry and stock buybacks have been the primary factors in surging profitability. However, these actions are finite in nature and inevitably it will come down to topline revenue growth. However, since consumer incomes have been cannibalized by suppressed wages and interest rates - there is nowhere left to generate further sales gains from in excess of population growth.So, while the markets have surged to "all-time highs" - for the majority of Americans who have little, or no, vested interest in the financial markets their view is markedly different. While the mainstream analysts and economists keep hoping with each passing year that this will be the year the economy comes roaring back - the reality is that all the stimulus and financial support available from the Fed, and the government, can't put a broken financial transmission system back together again. Eventually, the current disconnect between the economy and the markets will merge. My bet is that such a convergence is not likely to be a pleasant one."
- A rate of return sufficient to keep pace with the rate of inflation.
- Expectations based on realistic objectives. (The market does not compound at 8%, 6% or 4%)
- Higher rates of return require an exponential increase in the underlying risk profile. This tends to not work out well.
- You can replace lost capital - but you can't replace lost time. Time is a precious commodity that you cannot afford to waste.