Brent Sheather: Dow cracks 12,000 - so what

Last month was a record one for the US stockmarket with the 110-year-old Dow Jones index (DJI) of US shares closing on a new high, at 11,500. The bull market has continued into October with the world's most widely watched stockmarket index breaching 12,000.

Not surprisingly this piece of good news was met with much fanfare on Wall Street but local investors in US stocks will probably not be feeling so fortunate. While the DJI is arguably the best known measure of the US stockmarket it has just about no relevance to investment performance. In fact Mum and Dad in Remuera who bought the US market just after the millennium will, despite the 16 per cent rise in the last 12 months, still be looking at a loss of around 35 per cent.

Those who took professional advice and bought into tech stocks are showing a loss of more than 50 per cent.

But first some history : Back in December 1999 many local stockbrokers and financial planners had noted the recent stellar performance of US stocks compared to the local market and at the same time discovered the advantages of low cost, exchange traded, index funds. Accordingly, with a click on a mouse you could own 500 stocks and hop aboard the US stockmarket rocket. You were instantly diversified - thus there would be no problems with individual stocks going bust which had tended to spoil the party locally back in the late 80s.

With five year historic returns of 29 per cent a year and each day the kiwi dollar making new lows against the greenback, USA Inc was a sure bet and/or some cheap insurance on the lights going out in godzone.

Alas it has not turned out so well. Two of the most popular ways of investing in the US back then were via stock exchange listed index funds: the S&P500 Index Fund popularly known as Spiders and, if your financial adviser was really up with the play, the technology laden Nasdaq Index Tracker, known as QQQ.

Despite the DJI's stellar performance Spiders and QQQ are still well off their highs - some 13 per cent and 43 per cent respectively as at September 30. To see why we need to look at the make-up of the indices - the stocks which are included and their weightings.

Unfortunately the DJI is a very different index to the S&P500 and Nasdaq indices upon which the Spider and QQQ exchange traded funds are respectively based.

The DJI was created back in 1896 and is a much simpler index in that each of the 30 stocks (picked by a committee) is weighted according to its market price. Thus stocks with high prices, like IBM, have a higher weighting than stocks with low share prices.

There is of course no method to this - share prices just reflect the value of the company divided by the number of shares on issue. The DJI thus overweights stocks with fewer shares on issue, not necessarily bigger companies.

In contrast most modern indices are market capitalisation weighted: their market value (share price x number of shares on issue) as a percentage of the value of the total market. This system gives an index which is more representative of the impact of a stock on total market values and the economy as a whole. For example, IBM is the largest constituent in the Dow at 5.8 per cent but it is actually a much smaller company than, say, General Electric. Thus in the S&P500 Index it has a weighting of just over 1 per cent versus 3 per cent for GE.

But why has the DJI outperformed the S&P500 and Nasdaq? Simply because the DJI has an industrial, old style company focus whereas back in December 1999 tech stocks like Cisco, Intel and Microsoft had high valuations and thus comprised a big part of the S&P500 index and almost all of QQQ.

Critics also suggest that the DJI regularly drops companies which are not performing well which flatters performance but doesn't reflect reality.

Very little institutional money tracks the DJI index because, for a start, 30 shares is nowhere near enough to get a properly diversified portfolio (the experts reckon 50 is the bare minimum) and the process for picking stocks to go into and out of the index isn't transparent and has the potential to be manipulated by speculators.

As it is, one of the favourite games of hedge funds is to guess which stocks are going into and out of the S&P500 before the index trackers have to buy/sell them with resultant impact on prices.

But for New Zealand investors the other important factor affecting the performance of their US portfolios is the value of the dollar against the greenback.

In January 2000 one dollar could buy only US48.9c. Today's rate is around US65.71c so NZ-based investors in US stocks are looking at an additional currency loss of 26 per cent.

Consequently Mum and Dad in Remuera will, assuming growth of 8 per cent a year, probably have to wait another four years and six years respectively until they get their money back on Spiders and QQQ, unless of course the kiwi takes a dive.

Brent Sheather is a Whakatane-based investment adviser