Monday, January 21, 2008

The Stock Market Game (reprint)

Reprint from 4/27/07. The rest of the world has a head start on what may happen tomorrow (from examining the declines in foreign markets today). I thought this might be informative to those that missed it.

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. It 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
Intel Corp.---------------------1.3894----------22.16
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
Wal-Mart Stores Inc.-------3.1198-----------49.76
Walt Disney Co.-------------2.2119-----------35.28

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

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.

Copyright 2008 All rights reserved


Anonymous said...

Nice post!

Sackerson said...

The second graph is very striking - what an explosion over the past 20 years! Should it be adjusted for price inflation / money supply growth?

Jim in San Marcos said...

Hi Sack

I look at the general slope as an inflation rate. At some point you see the line increase dramatically. That's the part where the problem is. If the graph returns to the projected slope, it would imply that things are returning to normal. Otherwise the increase in the slope of the line would indicate that inflation is accelerating not just increasing.

The area under the curve for any one year span would if compared to the area of another one year span reflect the increase in the money supply.

I could be wrong on this, it wouldn't be the first time, we are dealing in economic theory. That's where you have 5 economists and 8 different opinions.

Sackerson said...

In the UK, think a lot of the inflation went into house prices. They've doubled since 2000, much like M4; the FTSE has never caught up with where it was end 1999.

Jim in San Marcos said...

Hi Sack

Another thing that really messes up property values in Great Britain is that the land is owned by someone other than the homeowner. The home value depends a lot on how much time is left on the land lease.

Two years left on you lease could make you a heavy beer drinker.

Sackerson said...

There's a lot of freehold as well as leasehold, but who ultimately owns land is a moot point, since the government can compulsorily purchase it (e.g. to build a motorway) and throw you off.

I'm not sure what the position is in the US. How far will your Constitution safeguard the private wealth you're literally sitting on?

zgirl said...

Sack, American property comes in freehold and leasehold flavors as well, though freehold (fee simple) is by far the more common. I cannot remember where I've seen leasehold, except Hawaii.

Our constitution requires the government to compensate us at market rate if they give us the boot under eminent domain. There can be political wrangling about what market rate is, of course, but there is some guarantee of compensation.

Eminent domain is now being used to boot homeowners in favor of other private uses like building shopping centers. There are some movements to reform and restrict eminent domain to better protect property owners, though I don't know of any major victories yet.

Sackerson said...

What is liberty without secure possession of your private property?

zgirl said...

Sackerson, do you know the expression "preaching to the choir"? :-)

We, as a nation, have decided that we, as a group, must make some sacrifices for the good of all. These sacrifices have been deemed to include being forced to sell our land so that job-creating, tax-paying business interests may put it to "better" use.

Wouldn't this be in keeping with what you argued was Christian charity when the government confiscates our income to provide for the common good, as in health care? If not, why would you hold land (a space to shelter and to grow a garden) more sacred than savings (which offers allows us to pay taxes on our shelter and to purchase food)?

Sackerson said...

Well, a can of worms, to use another well-known expression.

I understood that the American Revolution began (in part) as a revolt against tax. And I read elsewhere recently that the income multiplier on government spending turns $100 into $200, but in private hands turns $100 into $400. When did it become necessary for government to be so large and expensive? It seems many people want "the government" to solve all their problems (which just feeds the monster), while many others on the other side (at least in debate) sound as though they are prepared to watch the poor starve, satisfied that Nature itself is red in tooth and claw.

The last sickens me, but that doesn't mean that I think endless expenditure on "healthcare" is the answer. I think the concept of health is under-analysed, like that of happiness. I suspect that government and its hangers-on batten on the illusion that they can provide the solutions, when they may be adding to the problems.

Back in the 70s and 80s I read most of Ivan Illich's books. He's particularly revolutionary (i.e. as irritating to the State socialist as to the corporate capitalist), since he argues that institutions have their own logic and self-preservation instinct; they kidnap functions that we used to perform for ourselves (e.g. educating our children) and then do it worse, more expensively, and try to prevent us regaining our autonomy. Jesus, I understand, was similarly annoying to the apparatchiks of the established religion. It was reason against power, then and now.

I'd draw a distinction between being selfish and callous, as opposed to being free and independent. I will admit to no end of ignorance, but my imagination balks at the idea that late eighteenth-centruy Americans would lightly allow themselves to be turned off their own land. Maybe America has mutated beyond the point at which the Constitution as originally conceived could remain relevant. I hope not.

I live in a country that has a vague sham of a democracy and is even now changing the law so that your own internal organs are for the State to seize at the moment of your demise. I dream of a country where you can tell the government of the day to go to Hell and can reasonably expect the Comstitution to support you.

zgirl said...

"I dream of a country where you can tell the government of the day to go to Hell and can reasonably expect the Comstitution to support you."

Very, very well said. It is a can of worms, and I enjoy reading your perspective.

Part of the confusion may be due to how we define "needy". A conservative definition might be a person at imminent risk of starvation or homelessness. Let's call them "destitute." Next up the scale, you have people who are able to keep a roof over their heads & food on their table. Let's call them "poor." Then you have the solidly middle class. They can afford a home, food, a car - and then they have to allocate the rest of their dollars among health care, savings, plasma TVs, designer clothes, private school tuition, etc.

The argument isn't over whether people should starve, it's over who we feed and how we get them fed. Liberals/socialists would have the government feed them all. Conservatives would have charities feed the poorest, and create jobs to enable the rest to meet their own needs.

In the healthcare debate, we see people who can afford insurance - but choose, instead, to buy a new car or dine out frequently - demanding that the government provide health care. They claim that health care is a basic right, but they are really asking us to subsidize their standard of living - freeing health care dollars for cable TV and private school tuition and cell phones for every family member.

Most of us in high tax brackets got here because we understood the difference between a need (food) and a want (cell phone), and we lived within our means, which often meant no cell phone and very cheap food at some point in our lives. I ate ramen through school so I could pay taxes to keep high school dropouts in steak? No! Put that high school dropout into a jobs program, make her earn her handouts. Not "throw her to the lions!", just don't make me support someone who simply chooses to underacheive and still wants to live the lifestyle of an overachiever.

Jim in San Marcos said...

Hi Zgirl

Reading between the lines of what you wrote, it looks like government is a pretty poor determiner of who should get benefits. It's not cut and dry.

You made me think back to my college years on the GI Bill at$135 a month. Every month, I would buy a 100 pounds of cull potatoes and one pound of butter (gotta splurge a little). I only dragged one sack of them critters to the house, the burlap bag wore out on the drag to the apartment and I had potatoes everywhere.

I never really gave much thought to being poor, but by the time I was 40, my life had improved measurably.

I learned as you did that money is a tool, not a source of gratification.

Anonymous said...

the flat part of the log curve in the 1970s-1980s was a period of high inflation, so i don't think the log plot of the dji is linked to inflation. has anybody looked at the population growth curve relative to the dji log curve? i'll bet they match.

something else jumps out--the plot is basically linear over 100 years, with points on the graph being above the regression line just prior to the 29 crash and in the 1990s to present. i think the blogger said something to that effect--does it represent over-valuation in the market? somewhat compelling idea....