The Standard & Poor's 500 Index and the Dow Jones Industrial Average are the best known stock market indicators, but the way these averages are calculated make them hard to forecast accurately. So, I base my forecasts on the Value Line Arithmetic Average which is much more closely tied to the overall economy and business conditions.
Most of the time, most all stock market indexes give the same basic picture of the stock market. They go up and down at about the same time and by about the same amount as each other. For general purposes most any stock market index will provide a reasonable view of where stocks have been heading. But, to get a more accurate understanding of market behavior, the exact way that the index is calculated makes a real difference.
Articles I spotted this week in the New York Times and the Washington Post show dramatically how just two stocks, Boeing and Apple, have caused much of the price rise in the Dow and the S&P 500 this year. But, not in the same way. The impact of Boeing has been about 15 times as big on the Dow as on the S&P 500. Apple was responsible for about 14% of the rise in the S&P 500, but for only about 8% of the Dow's gain. Why has Boeing dominated the Dow, but Apple has dominated the S&P 500? Because of the way the indexes are calculated.
The original Dow Jones Composite was based on a simple calculation -- add up the closing prices of 30 great big companies, and follow that sum day by day. Over time the calculation has become more complicated to account for a changing mix of companies, but it remains totally based on price. Boeing at $237 per share today is a very expensive stock. Entirely because of its high price Boeing, up 50% for the year, is responsible for 25% of the rise in the Dow. But, here's the magic -- if Boeing were to authorize a 2-for-1 stock split, its price would be cut in half and its impact on the Dow Jones Industrial Average would be sliced in half. A stock split of Boeing at the start of the year would have significantly reduced the Dow's gains this year. Crazy!
The S&P 500, in contrast, is calculated based on the total market capitalization of each stock in the average: multiply the stock price by the number of shares of the company. The idea of following market capitalization is that what happens to huge companies is more important to investors and the economy than what happens to a smaller company. In the S&P 500, Apple Inc. is about 260 times more important than, for example, Chesapeake Energy Corporation.
Reliance on market capitalization makes the S&P 500 and similar averages like the NASDAQ Composite, prone to bubbles. As the Dot.Com bubble showed dramatically, soaring prices of a relatively small number of stocks does two things -- besides raising the index price directly, the increased prices raise the market capitalization of those stocks and therefore increase the amount that each bubbling stock counts in calculating the index.
The Value Line Arithmetic Average is calculated differently, and that makes a huge difference in predictability. The Value Line Arithmetic Average tracks the average percentage gain day-by-day of about 1700 very large U.S. companies. Changes in Boeing, Apple, Chesapeake Energy and many smaller companies all count equally.
Since 1984 the S&P 500 Average has matched a steady rate of growth about 86%. Yes, despite all the bumps and bubbles, the S&P 500 shows a "relatively" steady long term growth rate. But, the Value Line Arithmetic Average matched a steady growth rate with about 98% accuracy -- it gives a much less bumpy investment ride. (The Value Line Arithmetic Average is not available as an investment fund, but RSP, the Guggenheim S&P 500 Equal Weight ETF, has very similar performance.)
By using the Value Line Arithmetic Average as the basis of my forecasts, the predictions are much less vulnerable to the somewhat random price movements of a very few huge companies. It would hardly budge, for example, if simultaneously Boeing and Apple had major product flops. The Dow and S&P 500 would be tanking post haste.
For most purposes, most of the time, my forecasts for the Value Line Arithmetic Average will apply fairly well to other indexes like the S&P 500 and the Dow Jones Industrial Average.
As always, even though my forecasts for the past decade have been pretty good, at most, they should be only one of the factors an investor considers.
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