May

13

Stock market indices have the same problem that chain calculations of the cost of living have, but the difficulty of assaying what is added, left in and taken out should not deter us from accepting the common sense observation that wealth increases in open and competitive societies. It does so even though governments are always clipping the coins we use each day. The positive drift of the market seems to me the inescapable consequence of the increase in savings that comes from people having the liberty to trade. Part of that liberty is the ability to pick up and move to another jurisdiction where the local authorities are lying and cheating less. That freedom to light out for the territory with one's money has been the genius of our Federal political system. Every time wiser heads decide that open capital markets for money are a bad thing (Nixon, Ford and Carter's successive attempts at exchange controls being the most recent example) the drift stops being positive. If one needed proof that otherwise very smart people can refuse to learn this central lesson of American history, I offer Paul Volcker's recent proposal that the solution to the world's banking problems is to have a single currency. Fortunately, Americans and others throughout the world still have the ability to let Gresham's law work. When the competition among sovereign monies is eliminated, there will soon be no real drift at all no matter what index we use.

Laurence Glazier notes:

At an options seminar I attended last week, it was pointed out that there is an artificial aspect to the upward drift, as when indexes are rebalanced, dogs are dropped and stars added. The implication was that in fact there is no directional drift, as the ever growing index does not remain the same index. I don't believe it, but I had never considered this point before…

Phil McDonnell responds:

In some sense this kind of study has already been done. There is a fairly popular strategy that tries to predict when a stock will join the S&P 500 index and which ones will be dropped. For the most part it is a mechanical exercise based on market cap. Just before stocks join they tend to rise. Before they are dropped they tend to fall. But as an afterthought the dropped stocks rebound after being dropped. In other words this effect does not account for the drift because it tends to cancel out.

Another way to look at it is from the Dimson, Marsh & Staunton study of all major countries and all listed stocks for the last 100 years or so. This study did not look at existing indices where a pre-joining bump might be in effect. Rather it compiled its own comprehensive index of all stocks.

For another perspective consider the cap weighted vs. equal weighted indices. Over the last 3 years the Wilshire 5000 cap weighted has underperformed the Wilshire 500 equal weighted by about 15%.

Vince Fulco adds:

As for the quant desks on the Street, traditionally they start pumping out research as early as Feb-March trying to game the upcoming Russell rebalances in June. 


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