What's in a number?

24 November 2017 | Markets and economy

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Numbers can at times take on a significance way beyond the actual data point they represent.

Think significant birthdays – why is it that a 40th or 50th birthday seems so much more significant than a 39th or 51st? The answer lies somewhere within it being a marker, the passing of a significant milestone.

This month the benchmark Australian sharemarket index S&P/ ASX 200 closed above the 6000 mark sparking considerable media commentary and reflection of what it means for the future.

It was not the first time the index had breached the 6000 mark. The last time was January 2008, just before the global financial crisis sent economic shocks around the world and sharemarkets lost value dramatically.

For some commentators it was a time to celebrate the gain in value and the wealth created by the rise in sharemarket prices in Australia. For others it was a portent of worrying things to come given what unfolded last time we scaled those numeric heights with the broad market index.

For others it was a time to bemoan a "lost decade" given it has been almost 10 years since we were last there.

Investor opinions seem to naturally divide into two camps when these sort of markers are breached. The glass half full - those who decide now is the time to invest more - and the glass half empty types who argue it is time to take profits and retreat awaiting (hoping?) for a downturn.

Like any significant birthday, an index threshold moment presents a good opportunity to reflect a little on where we came from and where we might be headed – 7000 anyone or is a retreat more likely?

More fundamentally it is worth remembering what exactly the index is representing.

The major market indices like the S&P/ASX200; S&P500; FTSE 100; the Nasdaq Composite; and the global market index, the MSCI All-World have effectively become household investment brands in their own right courtesy of broad media exposure and industry adoption as the measure of gain or loss on those particular markets.

Indexes have become both a measure of market performance and an effective way to invest and capture market performance, courtesy of low cost index managed funds and ETFs.

But it is worth stepping back and lifting the hood on the market indexes to understand what you are investing in and what drives the value captured by the index.

Let's look at the S&P/ASX200 as our local market index. It is a market capitalisation-based index which means it includes the top 200 companies proportionately according to their market value.

So the top 10 companies in the S&P/ASX200 in order are;

  • Commonwealth Bank of Australia (CBA)
  • Westpac Banking Corp (WBC)
  • National Australia Bank (NAB)
  • BHP Billiton (BHP)
  • CSL Ltd (CSL)
  • Wesfarmers (WES) 
  • Telstra (TLS)
  • Woolworths (WOW)
  • Macquarie Group (MCQ)

Towards the bottom end of the 200 market cap weighting are companies like Myer Holdings (MYR), Australian Pharm (API), Flexigroup (FXL) and Greencross (GXL), all of which are represented in the bottom 10.

But what then drives the market index higher or lower on any given day? The prices of the companies included in the index obviously.

Here I will defer back to the father of indexing and Vanguard founder Jack Bogle who breaks the price of any given share into two components – the annual dividend yield plus the annual rate of earnings growth.

Amidst the short-term noise of sharemarket fluctuations investors at times lose sight of that fundamental link between the long-term growth in the market and the cumulative long-term returns earned by business.

It is a point well made by legendary investor Warren Buffett when he tells shareholders in Berkshire Hathaway that they should not expect to receive returns greater than the aggregate of the earnings of the businesses that Berkshire Hathaway owns.

While the Australian market has taken longer time to get back near its high point than other sharemarkets around the world took to reach new highs it is why it is worth looking at the return of the S&P/ASX 200 Total Return Index, which is arguably a better measure of the returns provided by the Australian companies included in the S&P/ASX200 where an investment of $10,000 invested in February 2008 would be worth $16,534 on 15 November 2017.

 

Written by Robin Bowerman, Head of Market Strategy and Communications at Vanguard.
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Robin Bowerman, Principal, Market Strategy & Communications at Vanguard Australia, shares investment and personal finance insights gained from over two decades in the finance industry as writer, commentator and editor.

Robin Bowerman