Dollars and Sense: Stock market sets new highs again

The stock market started the year with prices trading in a fairly narrow range without any clear sense of direction, However, this past week optimism took hold again, as the stock market achieved new highs for a number of indices.

This past week there was a specific milestone reached in one of the market averages. This was the Dow 30 index reaching 20,000 points for the first time ever.

The Dow 30 index is commonly quoted in the financial press. Part of its allure is that the index has been around for a very long time.

Most institutional investors tend to prefer using the S&P 500 index, as their benchmark for large company stocks, though among individual investors the Dow 30 is frequently referenced. When I reference the stock market, I typically am referring to the S&P 500.

As the name implies, the Dow 30 is an index of 30 stocks, while the S&P 500 consists of 500 companies. In addition the two indexes are constructed differently. The Dow 30 gets its price change by adding the prices of all its members, and then multiplying by a factor. A higher priced stock in the Dow 30 index carries more weight, because the same percentage change for a higher priced stock will impact the index more than the same percentage move for a lower priced security.

The S&P 500 weights stocks by their market capitalization. This means the largest companies have the greatest weight on the index. Therefore, the 100 largest companies in the S&P 500 index have more impact than the next 400. Among index funds a significant amount of money is aligned to the S&P 500, while a much smaller amount is indexed to the Dow 30.

Despite the significant differences between the Dow 30 and the S&P 500 their performance tends to be quite similar. Generally when one index is at a new high the other index is also at or close to record levels. There have been years when the two indexes have differed significantly, but most of the time their performance is quite similar. This is also the reason why an investor with a well diversified portfolio of 30 stocks can achieve performance similar to the S&P 500 without owning the entire index,

While the Dow 30 is an imperfect index, its reaching the 20,000 level did offer some significance to the investing public. This confirms that the stock market has done quite well, if someone has been a patient long term investor.

What might be of more significance to the average investor is not the specific number that the Dow 30 just reached, but the time it took for it to double. Going from 10,000 to 20,000 took just under 18 years. For those mathematically inclined that works out to an average annual return of 4% per year. That is just price change, as dividends over this time frame have averaged between 2 to 3% per year.

The performance over this time frame is somewhat less than the historical total return of the market, which has averaged closer to 10% per year. It should be noted that using 1999 as a base year, when the stock market was at a relatively high level makes it more difficult to achieve high returns in future years.

It should also be noted that the dividend yield for the Dow 30 approximated the inflation rate for the past 18 years, so the average annual rate of return of 4% per year is a return adjusted for inflation.

What this return should also signify to the average investor, is that even buying into the market when it was relatively high, a long term investor still did quite well by investing in stocks. Over this 18 year period of time there were two very bad markets, yet an investor buying near the market top in 1999 still did considerably better than someone who would have just parked their money in savings accounts over this time frame.

For a long-term investor the expectation should be that the market averages will again double. With the market at a relatively high level, it will likely take a number of years for that to happen. It will not necessarily take 18 years, but will probably take a considerable time. Nonetheless, a long-term investor should still continue to expect to see returns greater than inflation going forward.