What the S&P/TSX Really Measures

Transcription

1 WHAT THE S&P/TSX REALLY MEASURES 1 What the S&P/TSX Really Measures In Chapter 2 of the textbook we explain the meaning and construction of index numbers. The examples we discussed were index numbers for the output of newsprint and steel. Both were relatively simple index numbers because each one showed the movement of just a single variable over time the quantity produced of some commodity. We also talked briefly about more complex index numbers, ones that show the movement of an average of several variables. A well-known example of such a complex index number is the Consumer Price Index (CPI), an index number showing the change in the average price of the many goods and services purchased by typical consumers. The CPI is more complex than the steel and newsprint index numbers that we examine in Chapter 2 because it is necessary to first compute the average price of the typical consumer s basket of goods and services. A simple average does not suffice; instead, it is necessary to compute a weighted average, where the weight used for each individual good or service reflects the importance, in dollar value, of that specific product in the consumer s overall purchases. Products that represent a very small share of consumers total expenditure, like sardines or toothpicks, will have a very small weight in the CPI. In contrast, items that represent large expenditures, like gasoline and housing, will have much larger weights. Another complex index number that is very well known in Canada is the S&P/TSX index. Here we explain what this index is, how it is constructed, and how to interpret its fluctuations. What Is the S&P/TSX? When you hear people talk about changes in the S&P/TSX, they are referring to what is properly called the S&P/TSX Composite Index. This is an index number designed to measure changes in the dollar value of the companies that have their stocks listed (and traded) on the Toronto Stock Exchange. Like all index numbers, it has a base year; the index takes a value of 1000 in its base year, which was Over three decades later, in June 2009, the S&P/TSX fluctuated between and A good day (for those people who own the shares) occurs when the index rises by 100 or 200 points. A bad day sees a decline of the same amount. But the index is quite volatile from day to day, and so most people place little importance on daily fluctuations; a daily change of 50 or 75 points, in either direction, is very common. Not all stocks traded on the Toronto Stock Exchange (TSE) are represented in the S&P/TSX Composite Index. The companies stocks included in the index compose more than 70 percent of the total market capitalization of all the companies traded on the TSE. (The market capitalization for each company is equal to its share price times the number of its outstanding shares.) Furthermore, the companies that are included are drawn from many different industries. So even though not every company is included in the S&P/TSX index, changes in the index are widely viewed as representing changes in overall stock-market values. As a result, when people speak of what the market is doing today, they are rarely referring to the behaviour of individual stock prices; instead, they are referring to the change in this broad index of stock-market values. Note also that the S&P/TSX is not a price index like the Consumer Price Index it is a value index. In other words, it does not measure the change in the average stock price; instead, it measures the change in average market value, or market capitalization. However, since any firm s market capitalization is equal to that firm s share price times

2 2 WHAT THE S&P/TSX REALLY MEASURES the number of its outstanding shares, it follows that changes in the share s price lead to a change in that firm s market value if the number of outstanding shares does not change. On most days, the number of outstanding shares for any specific firm is not changing, so fluctuations in its share price directly cause changes in its market capitalization. A 3-percent increase in the share price will result in a 3-percent increase in the firm s market capitalization. But occasionally firms will either issue new shares or buy back some of their existing shares, and such changes in the number of outstanding shares imply that we cannot always identify changes in the S&P/TSX index with changes in average stock prices. Keep in mind that the S&P/TSX Composite Index measures the change in the average market value of the various companies that it includes. How Is the S&P/ TSX Constructed? The S&P/TSX Composite Index is constructed and published by Standard & Poor s, a company with a long history of providing financial-market analysis and services. The S&P Canadian Index Committee is a group of people within Standard & Poor s that operates the S&P/TSX Composite Index. It has established guidelines for maintaining the index. Which companies are represented in the index, and which ones are not? Four conditions must be satisfied in order for a company to be included. First, the company s stock must be listed on the Toronto Stock Exchange (which, in turn, requires that the company issuing the stock satisfies specific regulatory requirements regarding its method of accounting and reporting, as well as other details). Second, the company must be incorporated in Canada. Third, the company s float market capitalization must exceed $250 million, where the float market capitalization is the company s total market capitalization minus the value of those shares held by blocks that control 20 percent or more of the stock. Fourth, the stock must be actively and regularly traded in order to be included in the index; in other words, the stock must be sufficiently liquid. The composition of the S&P/TSX index is reviewed every quarter by the committee, when some firms are added to the index and others are removed. Once a company no longer satisfies the four conditions listed above, it is removed from the index. Similarly, after a company newly satisfies the four conditions (based on data from the previous year), its stock is added to the index. With this regular and frequent renewal, the committee ensures that the S&P/TSX Composite Index provides an accurate representation of the average stock-market values of the largest firms traded on the TSE. As of December 31, 2008, the stocks of 220 companies were represented in the S&P/TSX index, with a combined market capitalization of $941 billion. (Just for comparison purposes, note that Canadian national income in that year was $1600 billion.) The average market capitalization among the represented firms was $4.3 billion, with the largest being $50.5 billion (Royal Bank of Canada). Table 1 shows the companies that are most heavily represented in the S&P/TSX index the firms whose market values enter the index with the largest weight. The weights on the various firms add up to 1, and each weight represents that firm s share in the total market capitalization of all firms represented in the index. For example, the weight of 5.36 percent for the Royal Bank is equal to its fraction of the combined market capitalization of all the firms included in the S&P/TSX Composite Index. 1 1 Note that with changes in firms market capitalization, the firms represented in the top ten list change over time. Five of the firms listed in Table 1 were not among the top ten in December 2005, only three years earlier.

3 WHAT THE S&P/TSX REALLY MEASURES 3 TABLE 1 Top Ten Companies in the S&P/TSX Composite Index (as of December 31, 2008) Float Market Capitalization Weight in Index Company (billions of $) (%) Sector 1. Royal Bank of Canada Financial 2. Encana Corporation Energy 3. Barrick Gold Corp Materials 4. Toronto-Dominion Bank Financial 5. Bank of Nova Scotia Financial 6. Manulife Financial Corp Financial 7. Goldcorp Inc Materials 8. Potash Corp. of Saskatchewan Materials 9. Canadian Natural Resources Energy 10. Research In Motion Ltd Information Technology All 210 Other Companies (Source: S&P Indices and the Toronto Stock Exchange.) As the table clearly shows, the most heavily represented companies in the S&P/ TSX index are mostly from the financial and energy sectors, and each is virtually a household name in Canada. These two sectors each account for more than one quarter of the total market value of the companies traded on the TSX. The next largest sector is the materials sector, in which firms represent almost 18 percent of total market value. The remaining sectors range from industrials (just over 5 percent) to health care (just over 1 percent). Finally, notice that the ten largest companies, taken together, represent just over one-third of the total market capitalization of all the firms represented in the index. It follows that very significant changes in the overall index can occur even if the stock prices for the ten largest firms do not change at all. This brings us to our final discussion: How should we interpret changes in the S&P/ TSX Composite Index? Interpreting Changes in the S&P/TSX When the anchor on the nightly news announces that the S&P/TSX soared that day by more than 2 percent, many shareholders across the country smile to themselves, secure in the knowledge that their financial investments are doing well. And when, a few days later, the same person announces that the S&P/TSX plunged that day by 2 percent, those same shareholders wonder how long it will take their portfolio values to recover, and whether they should adjust their investment strategies. But should they respond in such ways to announced changes in the S&P/TSX index? What matters (or should matter) for any individual investor who owns stocks in one or more companies is how well those specific investments are doing, not how the overall S&P/TSX index is doing. Since changes in the index represent the change in the weighted average market value across over 200 companies, it is almost always the case that many individual stock prices move in the opposite direction from the overall

4 4 WHAT THE S&P/TSX REALLY MEASURES FIGURE 1 The S&P/ TSX Index, January 1987 April The S&P/TSX index displays considerable volatility during selected periods, but over the long term shows a clear upward tendency. (Source: From Statistics Canada s CANSIM database, Series V ) index. For example, even though the S&P/TSX index may increase on some day by, say, 2 percent, a large number of individual share prices will also fall. Similarly, on days when the S&P/TSX declines by 2 percent, there are many individual stock prices that rise. For any owner of individual stocks, what matters is the change in the price of the specific stocks they own, rather than the change in the overall stock-market index. Furthermore, many investors who own stocks pay little or no attention to daily fluctuations either in the prices of the stocks they own or in the overall S&P/TSX index. They often ignore daily changes in stock prices for the simple reason that these prices are quite volatile, often rising by 1 percent one day and falling by 1 percent the next. It is true that some investors hold their stocks for only short periods of time, and so daily fluctuations in their portfolio values take on a greater importance. At the extreme case there are day traders who purchase stocks in the morning and sell them before the end of the business day; for these very-short-term investors, daily fluctuations are obviously quite important. But for the majority of investors who hold their portfolios for much longer periods of time several months and even several years daily fluctuations are almost irrelevant. What is much more important to longer-term investors is the longer-term trend in their portfolio value the rise (or fall) in stock prices over periods of many months or several years. As is clear in Figure 1, the path of the S&P/TSX from January 1987 to June 2009 shows relatively long periods in which there has been a clear overall trend. For example, from 2000 to 2002, the S&P/TSX Composite index declined sharply, from to Such a long-term decline in stock-market values is often referred to as a bear market. However, over the next five years, the broad stock-market index increased from 6000 to just over This kind of longer-term market upswing is often called a bull market. A bear market then returned dramatically, as the index

5 WHAT THE S&P/TSX REALLY MEASURES 5 fell sharply in the summer and fall of 2008 from to just over If one looks at the entire 22-year period, however, there is a clear upward trend in the data: Despite the considerable volatility at various points within the period, the stock-market index rose from less than 4000 in 1987 to over years later. There are also relatively long periods during which there is neither a bull nor a bear market. For example, for the two years following the autumn of 1997, the S&P/ TSX index fluctuated around a value of 7000, but showed no sustained movements either upward or downward. During these times it is often said that the market is just moving horizontally up a little, down a little, but with no clear upward or downward trend. *** If you would like more information about what goes on inside the stock market, and whether it is a vital economic institution or more like a gambling casino, you can read A Beginner s Guide to the Stock Market, another Additional Topic posted in both Chapters 15 and 28 on this textbook s MyEconLab.