Why Stock Market Indexes Are Meaningless In a Digital Economy

Measures that muddle. Especially in an economy driven by intangibles and other data not even captured by the traditional financial reports on which such 'financial' indexes are based. JL


Alexis Madrigal reports in The Atlantic:

GE’s out of the Dow and Walgreens is in. Each of them employs more people than Facebook, which has triple the market cap of GE and Walgreens combined. The things investors value about Amazon and Facebook - get huge and dominate markets with incredibly high margins—are not reflected in earnings reports. Earnings explains 2.4% of variation in stock returns for a 21st-century company which means 98% of the variation in companies’ stock returns are not explained by their annual earnings. The mathematical precision of the stock market does not map well to the messy realities of the economy.

General Electric, which has been a component of the Dow Jones Industrial Average since Teddy Roosevelt was president in 1907, will be pulled out of the basket of 30 stocks. It’ll be replaced by ... Walgreens.
Why’d GE get bounced? It probably has something to do with the company’s fortunes. While it still generates a tremendous amount of revenue—$120 billion in 2017—its margins have fallen, and it swung into the red in each of the past two quarters. As a result, GE’s shares have fallen roughly 60 percent, from highs close to $32 per share at the end of 2016 down to today’s close at $12.88. Its shares performed the worst of any in the Dow last year.

The index is supposed to represent the country’s 30 biggest, best companies out of the more than 3,500 publicly listed corporations. The committee that oversees the index did not give a technical reason for the demotion. Instead, David Blitzer, the chairman of the index committee at S&P Dow Jones Indices, gave a more nuanced statement, referencing GE’s continuous inclusion since 1907.

Since then the U.S. economy has changed: Consumer, finance, health care, and technology companies are more prominent today and the relative importance of industrial companies is less. Walgreens is a national retail drugstore chain offering prescription and nonprescription drugs, related health services, and general goods. With its addition, the DJIA will be more representative of the consumer and health-care sectors of the U.S. economy. Today’s change to the DJIA will make the index a better measure of the economy and the stock market.

If you’re thinking, “That sounds kind of arbitrary,” you’re not wrong. How does adding up the share prices of 30 handpicked stocks and then dividing by a mutable “divisor” to normalize the index into a single number measure “the economy and the stock market”?

Well, the DJIA has tracked the S&P 500 remarkably well through time. As the longest-running important stock market index, the DJIA allows for historical comparisons that stretch back over 100 years. That’s useful. There is a nostalgic comfort in thinking that the same single number, composed of a potpourri of well-known companies nominally headquartered in this country, represent the American role in the massively complex, globalized economy.

However: The index probably can’t include the really high-priced stocks like Google and Amazon. Back in 2012, Adam Davidson argued that the index isn’t even a good measure of the companies that it contains, because the price of an individual share of a company is not the best measure of its value to investors. If all you do is add up the share prices and then divide, you get strange results. Given the same market value, a company with fewer shares outstanding will have a higher share price—and therefore a bigger impact on the index—than a company with more shares outstanding. And if you have a huge market cap and fewer shares outstanding, then you get share prices like Amazon’s, which is trading over $1,750 today. Walgreens shares are trading below $70. Would it make sense to have Amazon’s impact on the index hit at more than 25 times Walgreens’s? What’s the point of a bundle of stocks at that point?
Nonetheless, this is the way that the DJIA has done things before, so that’s the way it continues.
Besides, share prices are, themselves, becoming detached from the traditional measures of value for companies. Digital companies, in particular, are valued differently from industrial giants like GE, three business-school professors argued in the Harvard Business Review.
“Accounting earnings are practically irrelevant for digital companies the professors wrote. The things that investors value about Amazon and Facebook—the chance they will get huge and dominate markets with incredibly high margins—are not reflected in earnings reports.

“In another study, we show that earnings explains only 2.4 percent of variation in stock returns for a 21st-century company—which means that almost 98 percent of the variation in companies’ annual stock returns are not explained by their annual earnings,” they continue.
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.
Amazon certainly seems like a more important company. But is it 9.3 times more important? The mathematical precision of the stock market, no matter how it’s indexed, just does not map well onto the messy realities of the economy.
If what we want is a snapshot of the economy, like the real one that you and I live and work in, then the Dow Jones Industrial Average, and the rest of the stock market, are probably not the best indicators for the average American.

“The stock market might actually be our worst option. Rather than being a useful indicator, it’s an anxiety-amplification device. It reflects investors’ own reactions, and often hysterical overreactions, as they progress through the turmoil,” Davidson wrote. “It’s also not without intrinsic randomness. The Dow average, drawn out to two decimal places, may seem like some perfectly scientific number, but it’s far from it.”
It was helpful in the past to be able to answer the question, “Were the markets up or down?”—by which most people meant, “Was it a good day for the economy?” It was even more helpful to have that answer be a number that could tracked over time. But the DJIA is a vestige of a time when people didn’t have nearly as much access to different kinds of information about companies or the economy more broadly.
So, GE’s out of the Dow Industrial Average and Walgreens is in. Each of them employs an order of magnitude more people than Facebook, which has triple the market capitalization of GE and Walgreens combined. How do these numbers relate to each other or the lived reality of people with hourly wages or salaries?
The world still spins, and the stock market goes up and down.