The Evil of Indexes

Share indexes were created by a newspaper editor for the purpose of coming up with stories, a bit like political polls

Alan Kohler, Editor-at-large, The Australian Business Review  Melbourne @AlanKohler  10 Feb 2018

Charles Dow and Edward Jones have a lot to answer for. Without them we might not have share indexes and that would be a very good thing indeed: indexes have been, and still are, a blight on humanity.

I’m only half-joking, not even half really, and anyway it’s way too late, of course. That genie is well and truly out of the bottle and has been causing havoc for more than a century.

What happened this week, and seems to be still happening, was an overdue and oversized (already) adjustment to share prices, in the expectation of a faster lift in interest rates than was previously expected. Forecasts of economic growth and profits haven’t changed; if anything they have grown, but the discount rate for figuring out the present value of future cash flows has had to be tuned.

In preview, I’m going to argue that share indexes always make that normal process far more dangerous than it should be, and that the invention in 1885 by the then editor of The Wall Street Journal, Charles Dow, with the help of a statistician mate, Edward Jones, of the Dow Jones Transportation Average, and then 11 years later, the Dow Jones Industrial Average, were disasters for the calm functioning of capitalism.

It led, 122 years later, to this week’s headlines that “$61 billion was wiped off the value of Australian shares”, and much greater absurdities, and miseries, along the way.

Share indexes were created by a newspaper editor for the purpose of coming up with stories, a bit like political polls. They have no meaning except as a catchy way of summing up a mythical thing called “the sharemarket”.

If that’s all they did, then no problem, but the evil of indexes is embodied in the occupation of their creator: it’s not so much their calculation that’s the problem, but their publication.

Every day we finance journalists dutifully report the small movements of the Dow Jones, the S&P 500, the ASX 200 and the All Ordinaries, usually to a million glazed eyes.

But every now and then, to the delight of Charles Dow’s editorial successors, the indexes take a big dive. “Billions wiped”, say the headlines, and the stories report something terrible has happened and quote people, usually with some kind of vested interest, saying things could get much worse.

Circulation, ratings and clicks jerk upwards because, as always, fear sells. So the original purpose of share indexes was, I’m arguing, to generate fear to stimulate newspaper readership and TV ratings. But now they’ve gone far beyond that, with a myriad investment strategies focused entirely on indexes alone. For example, a key influence this week has been the VIX index, which measures the rises and falls of options to buy and sell the S&P 500 index. A lucrative game this past 12 months or so has been to bet that the VIX will fall — sort of like picking up pennies in front of a steamroller — and the responses of those gamblers to being wrong this week has contributed a lot to the volatility they are betting against.

And, of course, there’s now an entire class of investments based on those indexes, called exchange traded funds, or ETFs. Through them people can actually invest in the index, as if it’s a thing that can itself provide a return. It’s an idea that might have briefly crept into Charles Dow’s mind, before he pushed it aside, saying “No, that’s crazy! Investing in companies based on nothing more than their size? That won’t work.”

But Dow would be amazed and delighted by the ETF industry, since people are now not just titillated and frightened by the headlines, they have their savings in them and are doubly engaged.

The stockmarket is a place where those who own small pieces of companies, mostly known as ordinary shares, can trade them with each other. Companies began issuing pieces of ownership to raise capital, instead of borrowing the money, because the banks and bond holders had mortgaged all the assets and wouldn’t lend any more. So some bright spark, probably the Dutch East India Company in 1602, realised you could relieve individuals of their cash by providing a piece of paper that confers part-ownership, with the illusion of democratic involvement in management, plus the possibility (not the promise, mind) of a dividend. The first owners of these pieces of paper soon went looking for greater fools to sell them to, and thus began the stock exchange, and stockbrokers.

They started off meeting under certain trees and then in cafes, and eventually the brokers became so rich from clipping the trades that they built great edifices to conduct their business, and masonic-style monopolies to control it.

Eventually analysts appeared, with pencils behind their ears, purporting to value the companies and to recommend which ones to buy or sell, and when. Each company on the sharemarket is priced individually, according to a silent debate about its own future prospects. For large companies, analysts try to price those future prospects by subtracting the time value of money (the “discount rate”). An increase in that discount rate is what happened this week.

And it’s true that some elements of those future prospects are common to all companies — the economy and the tax rate are two. But what each firm does with those things is very different.

The share index, however, lumps all of these different things together into a class of investments called “equities” as if they are run by identical automatons doing identical things for the same customers, paying the same tax.

Nothing could be further from the truth.

Original article here

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