The evils of in­dexes we could do without

The Weekend Australian - - BUSINESS REVIEW - ALAN KOHLER

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 in- dexes 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.


Soured bets on the VIX have raised the mar­ket volatil­ity

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