Wednesday, April 25, 2007

The Stock Market Game

The "Dow Jones Industrial Average" sounds impressive. Right now it’s at 13,000. Add up the value of all thirty stocks in the DOW and you get 1,600. Hmmm where does the 13,000 come from?

There is the Dow divisor index which is currently at 0.1248 is a peculiar animal. Here is a cut and paste from Wikipedia

Assume an index comprising on 2 stocks A and B.
A is priced at $100 and B is priced at $200.
Hence the index value in this case is (100+200)/2=150
(where N=2 which is index divisor). So the index value here is 150.

Now assume stock B undergoes 2:1 stock split so its value becomes $100.
Now the index value would become 100 instead of 150.
To correct his irregularity we need to do the index divisor calculation as
(100+100)/N=150 (Since Market Capitalization of the stock is unchanged).
Hence, upon calculation we get the value of N as 1.333.
This shows that a stock split caused the index divisor to be revised
from a value of 2 to 1.33.


Today with the DOW, you would take 1600/.1248=12,820

DOW 30 Stocks---------------Weight %-----Present Value
3M Co.--------------------------4.8746---------77.75
Alcoa Inc-----------------------2.15-------------34.37
Altria Group-------------------4.3605---------69.55
American Express------------3.8245---------61
American International ----4.3593---------69.53
AT&T Inc--------------------- 2.4997---------39.87
Boeing Co. --------------------5.8489---------93.29
Caterpillar Inc. --------------4.5028---------71.82
Citigroup Inc. ----------------3.3492---------53.42
Coca-Cola Co. ----------------3.2659---------52.09
DuPont------------------------ 3.0897---------49.28
Exxon Mobil Corp. ----------5.0007---------79.76
General Electric Co.---------2.2025---------35.13
General Motors Corp.-------1.9862---------31.68
Hewlett-Packard Co.--------2.5937----------41.37
Home Depot Inc.------------2.4583---------39.21
Honeywell-------------------- 3.2226---------51.4
Intel Corp.--------------------1.3894----------22.16
IBM----------------------------5.9298---------94.58
Johnson & Johnson---------4.0828---------65.12
JPMorgan Chase & Co.-----3.2941---------52.54
McDonald's Corp.-----------3.032-----------48.36
Merck & Co. Inc.-------------3.2282---------51.49
Microsoft Corp.--------------1.8194----------29.02
Pfizer Inc.---------------------1.6909---------26.97
Procter & Gamble-----------4-----------------63.8
United Technologies-------4.2307----------67.48
Verizon-----------------------2.3768----------37.91
Wal-Mart Stores Inc.------3.1198---------49.76
Walt Disney Co.------------2.2119---------35.28
Total------------------------99.9998------1594.99


If you examine the Market Weighted %, this is the actual amount the Dow swings per dollar for each individual stock. Notice that a 5 dollar move in IBM translates into 30 points on the DOW (5 x 5.92). A 5 dollar move in Intel translates into 7 points on the DOW (5 x 1.38).


As boring as all of this is, its rather like doing 20 miles per hour in a car and the Manufacturer decides to add another zero to the speedometer and make it 200. In that scenario, you can go through a hospital zone at 200 mph and not suck the drapes out of the rooms.

DOW 13,000 sounds super, but when you add it up you begin to realize that the perspective is a little misleading. The DJIA 30 stocks are worth $1600. The real validity of the DOW hitting 13,000 has more to do with someone who bought into the market in about the year 1910.

The next picture is a logarithmic rendering of the DJIA over the last 100 years. The slope of the graph is linear. On logarithmic paper that's not a good thing. It could indicate a bubble, or the last step before hyperinflation (slope equals inflation rate). (Click on the graph for a larger picture)



The area under the graph line could be considered the measure of value paid for all stocks in the market. For that reason I have included the next graph which is linear. The crash of 1929 and 1987 are not very noticeable. This one, puts in perspective the large amount of money moving into the market. (Click for a larger picture)



---------------Picture from http://visualizingeconomics.com

The DJIA broke through 13,000 today or $1,600 (if you do the math my way). Both graphs tells a story. One is logarithmic because it was too big to fit on a page without losing detail. The other suggests that 1929 and 1987 were non events (that should raise an eyebrow or two).

On the positive side, the Dow's a lot more liquid than the housing market. Stockmarkets are not sticky on the down side! At one time Wall Street offered "Cradle to Grave Service." There was a nursery at one end of the street and a grave yard at the other. The grave yard is still there.

6 comments:

shtove said...

Good blog. And you got in early, and seem consistent.

Jim in San Marcos said...

Thank you Shtove

Every complement counts, you don't get a paycheck for blogging. Its the ataboys that make it worth while.

Thank you again

Jim

Anonymous said...

You need to account for inflation if you are going to talk on these time scales.

Check out:
http://homepage.mac.com/ttsmyf/
for a better explanation.

Jim in San Marcos said...

Hi Anon

You're right, there is more to the subject. The link is well worth reading. It's kind of hard to focus on one item without seeing the overlap. Inflation Vs Appreciation Vs Speculation.

This article I wrote, I considered rather long. I usually try to cut them down to about 1 1/2 screens. The biggest problem with blogging is knowing when to shut up. Some bloggers assume that their audience will read forever.

Thank you for the link--Its scary!

Anonymous said...

Good blog, but I do disagree with your statement that
"The slope of the graph is linear. On logarithmic paper that's not a good thing"

A linear slope on a log graph just means a constant COMPOUNDED growth rate. The rate itself could be low or high. It's really the magnitude of the linear slope that will determine if you can say "it's a good thing" or not.

Log graph are the most useful to normalize growth rates - or declines. Any double in the DJIA shows up as the same vertical rise on the chart (one major division on the y-axis). As does a 50% drop. A 25% drop or 50% rise takes half a major division.

Thus, with a log chart, you can eyeball the 1929 crash and see that it's about 3 major divisions, or 1/2*1/2*1/2, or 1/8 of the peak to the trough. AND clearly see that nothing has been close since.

Log charts make it easy to compare spikes up or down. Something 2x the y-distance is twice the % up, or 1/2 the % down. You can eyeball the number of years it took to double in price without having to consider the value of the y-axis (as long as you know the size of the division indicating a double).

Linear charts for stock prices are useful only when dealing with a relatively short time period when fixed amounts rather that percentages are being looked at.

Jim in San Marcos said...

Anon

You raise an interesting point. I was viewing the line as representing inflation, and you look at it as growth. Its probably a combination of both. Between the two of us, we may get it right.

What concerns me, is the second graph. The area under the curve from 1996 to present shows a doubling from the area from 1986 to 1996. This doubling I am figuring is linked to an increase in perceived wealth and an increase in M3, the money supply.

You have changed the way I look at that graph, thanks for your input