What is the Market?

“How’s the market these days?”

That, or some variation of it, is a question I hear quite a bit once people learn my vocation. It is a pertinent question given the shift away from pension plans and into defined contribution (i.e. 401(k), 403(b)) plans in the retirement landscape. Paradoxically, it is at the same time non-pertinent. Daily fluctuations in stock prices are mostly random and an investor is best-suited to ignore them. The goal for this blog is to define not only what most people mean when they say ‘market,’ but also to understand what drives prices of stocks, bonds, and other securities.

The Dow Jones Industrial Average was created on May 26, 1896 by financial reporters Charles Dow and Edward Jones. The initial index was twelve companies meant to serve as a barometer for American industry at the time. It expanded to thirty companies in 1929 where it has remained to this day. Colloquially, the current state of ‘The Dow’ is what most people are after when asking the question from the opening of this blog. As one can imagine, American industry, and the companies which comprise the index, are vastly different today than what we saw in 1896. In fact, General Electric’s removal in 2018 marked the end of over 120 years in the index for the last remaining original company – an impressive run.

GE was replaced by Walgreens Boots Alliance in what some might view as a curious move in the “industrial” Dow given the source of revenues for each company. It is important to understand that stock price plays an important role in the construction of the Dow. As a price-weighted index, a stock with too low a price will not have much impact on the movement of the overall index. As GE’s price moved into the low-teens and eventually the mid-single digits, they got shown the door. Conversely, a stock with too high a price will have an outsized effect on the index. For this reason, companies with sky-high stock prices (think AMZN and GOOG) are naturally excluded from the index. The Dow’s cousin – the S&P 500 – is constructed via a market capitalization weighting system thereby granting more influence to the largest companies as defined by stock price multiplied by outstanding shares. Despite the differences in construction and number of companies within, these indices are pretty similar in terms of performance. Exhibit 1 shows the relative performance over the last 10 years. There are some deviations, but overall, we arrive at the same point regardless of which index we observe.

Exhibit 1

Now, why the history lesson? To understand what moves the index that tracks the market, one must understand the levers that are being pulled internally. (Quick aside, there are thousands of indices that track every segment of the investable universe – we will focus on the most prominent.) Once we have a firm grasp on this, we need to move down a level to what changes the prices of the stocks within the index. Stock prices are the result of millions of buyers and sellers “agreeing” where the optimal price of a stock should be at that instant. As new information about the economy, the company, or really anything comes out, it quickly gets absorbed into forecasts and thus the price of the stock. That’s not all. There exists a spectrum of time with which a market participant should concern himself or herself. On one end we have high frequency traders who are looking to scalp pennies from transactions in a split-second. On the other end we have long-term investors like you and me with decades to invest. The disconnect between our investing time frame and what gets reported to us every day, minute, and second is immense. Yet we still fret. Why should we concern ourselves with what only matters to day traders and the like?

The answer lies within the wiring to our brains. As a species, we tend to place an exorbitant amount of weight on recent events and expect them to continue indefinitely into the future. This so-called recency bias is pervasive everywhere, not just in the stock market. This bias is amplified by the news cycle meant to keep our eyes glued to the television, our computer, or our smart phone. How boring would it be if a news anchor reported that long-term trends remain in tact every single night? Instead, “DOW PLUMMETS 500 POINTS” will make you worry. And worrying will keep you watching.

Let’s tie this together with a takeaway. Exhibit 2 is a great way to visualize how we should approach our finances. The stock market, the economy, and decisions from the Federal Reserve fall squarely into the left circle (no pun intended). Unfortunately, they are nowhere to be found in the right circle. What resides in the middle section includes things like how much you save and controlling your reactions when the stock market drops. And next time somebody asks you if you are seeing what’s happening in the market, smile and ask them to define their timeframe and ask which market.

Exhibit 2