The Meaninglessness of the Stock Market Index in a Digital World | Hacker News Reader

The Meaninglessness of the Stock Market Index in a Digital World

theatlantic.com

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There's a lot of failure to appreciate a simple fact: "1 share" is not a consistent, well-defined unit. It's just some arbitrary fraction of the value of a company, that fraction varying not only between companies but also over time, because of splits, secondary offerings, and buybacks. This seems like an obvious, straightforward fact that everybody knows, and yet historically, there has been a tendency to ignore it and to think the price of "a share" means something. Companies whose share prices are above $50 or so have been viewed as "blue chip"; those below $10 have been viewed as "speculative". There is thus a psychological component to the perception of share prices that is not justified by the mathematics of the situation; and much of this is a matter of convention. Even today, I believe that to continue to be listed on the NYSE or even NASDAQ, a company must not let its share price fall much under $1. The only effect of AMZN trading at $1730 is to make it difficult for small traders to trade the stock, since exchanges don't deal in fractional shares (they could, I suppose, but they don't).

We see this error in the way that Charles Dow and Edward Jones defined their index back in 1896 [0]. Averaging prices of shares in different companies is mathematically meaningless. But the author of this piece, having commented on this error, goes on to make it again: For example, for fiscal year 2017, Costco had earnings per share of $6.08. Amazon had earnings per share of $6.15. Costco’s market value is $91 billion; Amazon’s is $844 billion. EPS numbers aren't directly comparable any more than share prices are directly comparable. COST is trading around $209, less than 1/8 AMZN. Instead of EPS, we should be talking about earnings per dollar of market cap, which would be independent of the size of a share. On that measure, COST is outperforming AMZN by a factor of more than 8. (Along with juxtaposing EPS numbers from two different companies, the author seems to be committing a second error by suggesting that earnings and market cap should be related; they are not, at least not in any simple way.)

What’s the value of the company if not assets + all future earnings?

The market clearing price.

I mean, that's the theoretical value that you should pay for it, but markets don't always exactly match theory.

What about debt/liability?

I guess you might be referring to Enterprise Value ( EV ).

https://www.investopedia.com/terms/e/enterprisevalue.asp

Ultimately, the value of a company is what someone is willing to pay for it. So you could argue the value is EV + Premium.

Keep in mind that there is a bazillion ways of valuing a company. People look at growth potential of the company, the growth potential of the company's industry, the competition, external risks, buyout potential, etc. It's part business, part mathemagic and part voodoo.

What's the value of a 'future earning'?

Your idea of "earnings per dollar of market cap" is essentially the same as "earnings yield", or inverse of the P/E ratio, which is indeed much more meaningful than EPS

Earnings yield is a measure of how expensive a unit of earnings is, and can be compared across companies as a heuristic for "cheapness".

Another metric is free cash flow yield: free cash flow / market cap. Using operating free cash or operating profit like EBITDA gets you the cost of operating cash flow excluding non-operating stuff like interest, taxes and non cash depreciation expense

You can also use enterprise value as the denominator (market cap plus debt less cash) to capture the full picture of a company's capitalization

By buying groups of stocks based on these metrics, rather than just index funds, you can blend aspects of passive and active investing. This is called "smart beta" and is an interesting emerging strategy

A good primer is "the little book that beats the market". The strategy is to buy "cheap and good" stocks and just hold them. Cheap is defined by high EBIT / EV (lots of earning power per unit of capital) and good by high ROIC (the business can turn money into more money). So you filter by these two metrics, then buy the top x companies, buying one stock / month over a year to mitigate timing risk, and hold

I believe that you need to buy about 20-30 of these companies then hold each for about a year, to get long-term capital gains, then reevaluate. Greenblatt claims that statistically this will work.

The Magic Formula:

https://en.m.wikipedia.org/wiki/Magic_formula_investing

Has anyone tried it?

I haven't tried it though I find it intellectually appealing. Actually implementing it requires some config (do you want to include all industries, or exclude some like finance as greenblatt suggests? What range of market caps will you consider? US only or emerging markets? Do you short companies on the bottom of the list or do long only?)

I just haven't spent the time thinking through those things...

There's a good article on more current results here: https://seekingalpha.com/article/2944796-beating-the-little-...

Short version is that the alpha has shrunk considerably.

The Acquirer’s Multiple is another similar formula:

http://acquirersmultiple.com

One must be careful to avoid a "value trap". Occasionally, a company is inexpensive for a reason, and that reason can be hard to discern at a glance.

That is of course true. However, I've noticed many seem to justify any stock price being low as the market already pricing in all the information. However when you look at AAPL's valuation 1-2 years ago, shares went down to a low of around $90, which was only like 6-7 FCF or so (it's a little complicated cause you had to subtract apple's cash hoards but also multiply by some uncertainty factor < 1 that represented the probability that they would be able to bring the money back).

Meanwhile you have companies like MSFT, etc which while growing at a fast rate, are far, far more expensive on a FCF yield basis.

Ultimately - and this is pretty obvious but worth stating - you have to come up with your own valuation for a given company when making investment decisions.

That's a risk, but ROIC is supposed to somewhat counter that by ensuring the company is creating earnings from its invested capital (i.e. It's a "good" company). Can also only include large cap stocks and diversify to remove some of this risk

Regarding "Instead of EPS, we should be talking about earnings per dollar of market cap", isn't that what the P/E ratio measures? Although, strictly speaking you are suggesting the reciprocal - an E/P ratio.

I believe P/E ratios are far more widely used for comparing companies.

EPS isn't a completely useless measure - it can be useful to shareholders in the specific company to provide some anchor for judging dividend policy and for comparing performance over time for that particular company.

But I agree that EPS is a useless measure for comparing different companies.

We should never be talking about earnings per dollar of market cap (PE, as you've correctly noted) - the far superior metric is fcf per dollar of market cap. (Even FCF isn't a flawless metric, since it can be affected by one-offs, but those are generally easy to account for, whereas earnings being a pure accounting metric is vulnerable to all kinds of fuckery)

can you expand on that? Is FCF free cash flow?

Yes. Let me know if you want me to like actually expand on it (versus just wondering what FCF stood for)

how is FCF (normalized per market cap) a better metric? What kind of fuckery is P/E vulnerable to?

Sorry I’ve been swamped so i can’t actually do reaearch and give a full response so I’ll start with a tldr and hopefully come back and give you a real answer later:

earnings are an accounting measure and there’s some flexibility as to whether a given expense is classified as capex, opex, r&d, etc each with different earnings implementations.

In general I prefer cashflow to earnings for that reason.

The next point is cash flow vs free cash flow, fcf factors in capex, etc giving you an accirate idea of how much capital is free to distribute to shareholders (free meaning available).

As one example, look at tsla’s financials. Their gross margins / earnings paint a way better picture than their fcf, because they engage in all the accounting practices that I vaguely referenced above

thank you for taking the time to write this

Likewise people sometimes make the mistake of comparing prices for different cryptocurrencies. In the case of cryptocurrencies one should look at the market cap, which is the current price multiplied by the amount of coins or tokens available.

And that is why psycologists are winning Nobel's for economics these days. Tomorrow they will hopefully play a bigger role in engineering and tech.

I disagree. A share is worth a portion of the business. That is a defined unit. The share price is what people will pay for a share of the piece of company. Baked into the price is the underlying assets (real value) in addition to the fuzzy speculation piece.

The share prices can be analyzed by looking at the financial reports. True value can be assessed by looking at assets minus liability, debts, dividend payment, etc.

This value per share then is compared to the buying price. There is a lot of speculation built into the price now a days. An investor does not have to buy at this real value + speculation price, the investor can sit it out. People are willing to pay for a share of this company, a non-defined amount, it's the only way to continuously offer a share of the company for sale.

The Dow Jones index being a poor index (as well as being a price index) does not mean the idea of a stock market index is a poor one; the title of the article especially was poorly chosen by the editor. The S&P500 Index is another stock market index and is far from meaningless -- its level reflects expectations about the future profits of the largest 80% of American companies. The S&P500 has its own weaknesses because it does not fully capture the stock market (use something like the CRSP Total Stock Market Index or the Dow Jones U.S. Total Market Index) and because it is a price index (compare to the German DAX which is total return-based).

The article overreaches in its conclusions.

I think what the author is trying to point out here is that in the world we live in today the stock market indexes are less valuable. Stocks used to be able to be bought using technicals like the P/E ratio and other financial tools. As companies like facebook and snapchat and the likes. Companies whose values cannot really be calculated by the assets they hold (land, machines and factories etc). Their value is in their Brand, their IP and other subjective articles. But they are listed in the stock market and they dominate the stock market today. It generally makes these tools weaker in calculating the value of the market using stocks which was created for an industrial age

> Companies whose values cannot really be calculated by the assets they hold

Assets have value for the cash flows they promise. Facebook is a dead simple valuation exercise on a PEG basis.

Stock in Facebook is the same principle as stock in Ford. You are simply buying a share of the company. I don't see how indexing them is any less the beneficial now then it was twenty years ago

In March 2000, tech companies represented 35% of the S&P 500 by market cap.

Cisco was briefly the largest company in the world, with a market cap similar to Facebook today (taking inflation into account its market cap was similar to Amazon today).

https://www.bizjournals.com/sanjose/stories/2000/03/20/story...

These were the ten largest companies in the S&P 500 in January 2000: Microsoft, Cisco, Intel, IBM, AOL, Oracle, Dell, Sun, Qualcomm, and HP.

Agreed. These indices are extremely useful for trading.

For just under $275, just about anyone can buy a share of SPY and make/lose money based on trends across a diverse array of the largest companies in the world. Without indices, you'd have to spend tens or hundreds of thousands of dollars for this kind of diversification.

It's also useful for tracking trends within specific sectors. Think tech is undervalued? Invest in a NASDAQ ETF like QQQ or NDX. Maybe you read that OPEC is planning to increase oil production and you think that's going to devalue existing oil supplies, so you take a short position on XLE (an energy index ETF).

The relative simplicity of indices means there's a lot of volume and liquidity. It's not easy to find a buyer for shares in an obscure oil company, but lots of investors would be happy to buy your energy index ETF shares.

I love indices. I'd be hesitant to invest in sectors I don't know much about, like construction materials. They're heavily affected by the price of raw materials, and lately all this tariff talk has caused a lot of volatility in those prices. Which individual companies should I get involved with? It's hard to say without a fair bit of research because it's a specialized field. With an index ETF, I can quickly take a long or short position to get a little exposure to the sector without having to dig too deep.

Just a quick point of correction - be careful not to confuse an Index with an Index fund. You are talking about ETFs, which come in Index fund varieties, but the Index exists as a market indicator, not for the purpose of creating a fund. ETF providers use indices to create a very simple to maintain trading strategy and investment vehicle for low management cost, but they do not create the indexes.

Yes, you're correct. I didn't do a good job explaining the difference. I considered editing to add a note, but I think your comment explains it clearly enough to make that unnecessary.

> ETF providers use indices to create a very simple to maintain trading strategy and investment vehicle for low management cost, but they do not create the indexes.

It's rumored that Vanguard 'bribed' CRSP to create its Total Market index (and etc for other funds) so that its licensing fees to MSCI / Dow Jones would be lower. So while it is true they do not maintain the indices, it is possible they have a heavy role in creating the indices.

Yeah, I considered adding that Index funds "mostly" don't create indexes, but I'm sure that some do. And some ETFs have been created that almost track certain indexes. You see special ones that are mostly S&P500 without tobacco or without guns or some other ethical choice.

On a related note, there are a _lot_ of indices. FT reports that there are over 3 million stock indices, for ~50k public stocks [0]. You can make an index with basically anything in it. There are indices for emerging markets, for the Gulf region, for companies in Mexico, for companies which qualify as ESG (environmental, social, and governance) criteria. There are indices of stocks that historically perform well in periods of rising interest rates, and there are indices for the Eurozone.

The ETFs just build on top of the index. In almost every prospectus, there is some kind of note about which index it is. You can go look at how the index is arranged, and there are sometimes multiple funds that track indices in the same sectors, with different weights. If you're not happy with the amount of Berkshire in your financials ETF, you can go find a fund which uses a different index and buy that instead.

If anything, a stock market index is _more_ valuable in a digital world, because it effectively adds a layer of abstraction to the typical notion of investing.

[0] https://www.ft.com/content/9ad80998-fed5-11e7-9650-9c0ad2d7c...

Also, while buying & holding an ETF based on the S%P 500 is the canonical low-effort investing advise, it is trivially easy to beat this strategy by choosing an index that performs better historically. E.g. the Russel 2000 or some other index that captures the price movements of medium sized companies. The S&P 500 tracks the biggest companies, which necessarily are the ones that have done most of their growing already.

> it is trivially easy to beat this strategy by choosing an index that performs better historically.

Past performance is no guarantee...

This is a very subtle question which is far from resolved[1] in the academic literature; it is nowhere close to the slam-dunk you state it is.

[1]: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3122326

Once upon a time I got an undergrad degree in economics and accounting. I then later was awarded the CFA charter. Having cleared my throat with such wanton credential-ism, when kinds of articles come up I want to recommend strongly:

"A Random Walk Down Wall St" by Burton Malkiel [1]

Anyone wanting to have any kind of understanding of investing should have read it. Even if you already know it all from extensive study elsewhere it is important to see it all in one place, well written and explained. I say read it! Really!

You have a startup and you need to understand investing in your business - this is a flying start. I can think of no better.

[1] My affiliate wikipedia link https://en.wikipedia.org/wiki/A_Random_Walk_Down_Wall_Street

It seems like this author doesn't quite understand what they're trying to communicate here. I'm surprised this was published by the Atlantic which I generally regard as a competent media property. There's some fundamental misunderstandings of how finance works and what the DOW is vs. other indexes.

For example, he doesn't seem to understand that a company's valuation (his Amazon reference) is a function of its discounted future cash flows, not present value.

The Atlantic has really dropped in quality over the last few years - while also showing up more often in the social media echo-chambers. I ignore it now

Judging by publication name means you're missing out on some great authors. Ed Yong for science writing, for example.

The best way to do it is to subscribe to authors you think are good via RSS.

The sum of discounted future cash flows is present value.

All the professionals use the S&P 500 index.

The Dow Jones index is used only by the popular non-financial press.

Actually, if you could measure it globally, most institutional investors who measure/benchmark to the US stock market probably use the Russell 1000. You're point is still valid tough regarding cap weighted vs. price weighted.

The Wall Street Journal refers to the DJIA more often than the S&P 500, and they have a reasonable business section. They mostly do it because they're tied up with it, though.

No great loss to them, TFA notes that they're well correlated (and gossip about GE sells papers on slow news days.)

Would be curious to see a word frequency count of both in the WSJ.

Seems like Warren Buffet won his bet just investing in the index (S&P 500 not Dow) over a hedge fund.

"Buffett made the bet in December 2007, arguing that a fund holding the same stocks as found in the Standard & Poor's 500 index could beat the combined performance of a group of hedge funds over the following 10 years."

https://www.usatoday.com/story/money/markets/2018/03/07/warr...

That's questionable. 1998 - 2008 was a catastrophic investment period for the SAP500 (0.8x return or so). 2008 - 2018 was quite good (2-3x)

Warren bet that the S&P 500 would out perform a managed Hedge Fund.

And he would have been wrong 1998-2008, provided that the managed hedge fund literally just kept all their money in cash.

But did hedge funds keep their money in cash? Warren's point is exactly that the funds' decisions are not worth the cost.

It was a broad fund of hedge funds, the HFRI, if I remember correctly.

In particular, their 5% fees and profit (but not loss) sharing.

You're talking about a hypothetical fund with 20/20 hindsight.

I doubt anyone would pay 2% management fee and a 20% share on profit to a fund who is just going to keep the money in cash. Might as well do it myself for free.

I agree with you, but that isn't the point.

The point is, "Stick it in the SAP 500" would have been a losing proposition. You would have lost 20% of your money, and lost 10 years of opportunity cost to boot.

I get your point. But my point is that I doubt a hedge fund would have been performing better than the 20% loss of the S&P. Maybe it would have incurred a 40% loss. I think that in the investment world, action bias is very strong and literally doing nothing is not seen as a good thing.

We both agree that if you could have foreseen that decade, you would have sold all your stocks in 1998, put it on a savings account, and only have taken it out again in 2008.

I am glad we agree! I also 100% agree that the SAP500 may have performed better than plenty of funds 1998-2008. I'm sure we could even dig some up that did horribly. There were even funds 2008-2018 that liquidated during the Buffett bet :)

Managed hedged funds that put all their money in cash would likely lose money for the investor just from all the fees.

Hey, if you know a method to tell which years are better to keep money in cash than stocks (in advance), please, let us know!

You are missing the point. I conceded your point in the thread below.

Anyone who says "just stick it in the SAP500 and you'll make some money" is hiding the fact that even with a 10 year time-frame, that statement is not always true.

1998 - 2008 was a blood bath for many, despite the fact that you had 2 legitimate booms in there.

The question really is. Armed with that knowledge can you do any better without gambling?

If a basket of managed funds did the same or worse in that period then probably not for a passive investor.

I wonder what kind of bloodbath awaits us soon.

No he didn't. He bet the S&P500 would outperform a fund of funds. That's a colossal difference in meaning.

I think you missed Buffet's message. It was that Manager of Hedge Funds are not worth the fees they charge.

A Collection of Managed Hedge Funds UNDER performed the S&P 500.

Point - Managed funds are worth what they charge.

I didn't miss Buffett's message, because the only message he delivered through the bet was that a fund of funds underperforms the S&P 500. We cannot logically extrapolate the bet's conclusion about the aggregate industry to a conclusion about any particular fund; each fund must be examined on its own weight. There are plenty of fund managers who are worth the fees they charge, and drawing conclusions about their individual performance based on the aggregate performance of the industry is silly. Buffett didn't make any claim about individual funds.

I think it's not a one-time-investment at the beginning which is being measured, but a DCA (Dollar Cost Averaging) over a long period.

Ted Seides (who was on the other side of the bet) actually has some interesting counterpoints to make about it: https://www.bloomberg.com/view/articles/2017-05-03/why-i-los...

Not really.

He got beat fair and square and there are no excuses.

The whole point is hedge funds should do better otherwise what's the point of the management fees.

And if the point is to do worse in a rising market and then beat a falling market I can do that by putting 80% money in the S&P Tracker and 20% in cash and I won't charge a massive fee to do so.

The fund of funds index that Ted Seides put in already takes into account management fees -- it's what the investor will actually return.

And I do think it's necessary to put this bet into context, because the ultimate question it is trying to ask is "are managers adding any value?" Any sort of bet is going to be an artificial way to measure that, so the caveats to the bet that: this was during the longest bull market of all time; S&P 500 is USA weighted, which out-performed international counterparts; hedge funds still provided lower volatility are important.

I think the fact that Ted challenged Warren to another 10 year bet (which he refused) does speak to something.

And yet, despite all the errors in the article and the title, the basic premise, that stock market indices should not be used to talk about the economy as it is experienced by anyone other than those invested in stocks, is sound. Also, old news. I learned this in 1987.

Most of the stock market is nothing but speculation. Sure, "informed" speculation, but unless you have enough ownership in a company to have some kind of power in their decision making process (or have some other advantage like insider info), then you are just guessing what the future will be.

Haha, your comment actually made me laugh out loud.

I would be careful with choosing your words especially when in a marketplace, there are buyers or sellers whose entire goal is to speculate .

>It is controversial whether the presence of speculators increases or decreases short-term volatility in a market. Their provision of capital and information may help stabilize prices closer to their true values. On the other hand, crowd behavior and positive feedback loops in market participants may also increase volatility.

[https://en.m.wikipedia.org/wiki/Speculation]

Your comment made me scratch my head trying to figure out what you mean.

Anyways, it seems you are actually confirming the statement above about speculation in the stock market.

>> It is controversial...

Which means, it is not proven and maybe it can't be proven, hence any assertion about the point is just speculation about which side is right or wrong

There are a LOT more than 3500 publicly listed corporations.

Bloomberg says 3600:

https://www.bloomberg.com/view/articles/2018-04-09/where-hav...

That depends on if you mean securities or corporations. ETFs aren't counted as companies, and there is a hell of alot more of them than corporations.

and they are willfully ignoring the OTC market which has 10k+

There are a lot more than 3500 publicly listed corporations.

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