What is a Benchmark index?

US capital markets are moving upward, slowly but surely. The Dow Jones Industrial Average is up about ten percent, the Nasdaq Composite 23 percent and the S&P 500 13 percent since the beginning of the year.

Questions are always asked about these benchmarks (indexes). What are they and what does it mean to my mutual fund or portfolio of stocks?

Sometimes it means nothing, if your investments contain none of the benchmark holdings. Emotion (and not being left on the sidelines) drives markets too; thus, often when the indexes rise, so, too, may your portfolio under the clich? that a rising tide lifts all boats. Increases in indexes mean the average price of the stocks within that index are moving upward.

Where did the Dow Jones Index, the first benchmark come from? Dow Jones & Co, a publishing company founded in 1882, owns the Wall Street Journal. Trying to make market reports more comprehensible to bewildered investors (and readers of the paper), Charles Dow (one of the founders) was inspired to create a benchmark that would project general market conditions. Though a revolutionary idea at the time, its mathematical logic was simple, just use, well, plain old averages. To calculate the first average, Charles added up the stock prices of the companies in the index and divided by eleven, which was the total number of stocks in the Dow at that time.

While calculation of these averages has become more complex, the price-weighted method is still used. Detractors of the Dow Index say that it does not reflect the real weighting of a stock price; that a one dollar market value change for a ten dollar stock is a much more significant swing (percentage wise ten percent) than a one dollar change for a $100 stock (one percent). Because of price-weighting's associated problems, most all other major indexes such as the S&P500 are market-capitalisation weighted. Indeed, there are those who say that the Dow (because of its small number of stocks - 60) does not have the same significance that it once did. Many disagree with that premise, as we shall see below.

Today, the DJIA is still an influential benchmark for tracking American stocks. The editors of the Wall Street Journal still subjectively pick their positions on the Dow. Over the years, companies have been changed to reflect the American economy, only General Electric remains from the original group of eleven. The detailed descriptions of the Dow stocks, blue chip companies all, such as Boeing, GM, Merck, Microsoft, ExxonMobil, Walmart, General Electric, IBM, Caterpillar, Citigroup, and Home Depot can be found at http://www.djindexes.com/

Let's take a closer look at one of the economic leaders and its impact on capital markets.

Walmart tracks consumer patterns. Consider the impact of billions of dollars of moving inventory. Sam Walton, the shrewd genius that started the Walmart industry understood one hard fact. Inventory that does not sell (flying off the shelves is what he preferred) impairs profits. Day in and day out, the longer a piece of inventory sits unsold, the greater the carrying cost to the retailer. And those costs are many: the cost of interest on the cash float to finance the inventory purchase, the cost of redisplaying to keep the look attractive, the cost of labour from handling and rehandling, the cost of marketing, the cost of obsolescence and outdated styles.

Walmart combats opportunity costs lost. The most deadly cost, the subliminal one that cannot be measured, is the absolute cost of the consumer walking out of the store and shopping elsewhere because the inventory is tired, old and too pricey for that individual's economic circumstances. This cost is exponential because Walmart knows unequivocally that for every customer who walks out empty handed, they have lost the chance to sell not one, but many items in the future to that consumer. Because they know this and manage customer retention very well, they dominate in an industry where an often inexperienced small retail business owner makes the predominate mistake of clinging to their inventory, hoping to get full retail price.

Walmart rigorously applies technology. Because of their insistence on innovation they anticipate, see and understand almost instantaneously patterns in consumer spending. Every single purchase (or non-purchase) on a minute by minute, day-to-day record drives inventory control. In a just-in-time fashion, their demand (or lack thereof) creates: a huge ripple effect on thousands of manufacturers, increasing / decreasing production as needed; on banks and credit unions providing consumer loans; on farm and livestock production; on the commodities markets; on customer satisfaction and the outlook on the economy. This is the Walmart Customer Demographics phenomenon.

When Walmart talks, Wall Street Listens. Mega-giant Walmart reports revenue and consumer consumption trends on a weekly (and may be soon daily) basis. Monitored closely by capital markets, reactions to even temporary poor results can be brutal and swift, often taking the steam out of a good market day. Their insight into the economic mood of the American public equals (or even surpasses) Consumer Sentiment indexes as everyone, well, almost everyone, shops at Walmart. If a particular industry or sector of the US continent is heading toward higher job redundancies, Walmart can often spot the consumer doubt and retraction well ahead of unemployment office. Walmart knows we are creatures of habit, that we are fickle and that we vote with our pocketbooks. In periods of uncertainty, we may put off an elaborate vacation, but we will take more picnics closer to home. Bingo, up go sales of picnic coolers. Ladies may not buy that expensive dress, but will still purchase cosmetics. It is a research analyst fact that sales of lipstick increase in recessionary periods.

Imagine what Walmart will know about us all when they are able to penetrate the entire retail global picture, including China. Imagine how much influence Walmart will wield if they become a true provider of all things, including banking, investments, health care, insurance, automobiles, and so on. Don't think they aren't planning for this already. This, readers, is capital market influence and a primary reason for the use of benchmarks.

Martha Harris Myron CPA CFPr is a Bermudian, a Certified Financial Planner™(US license) practitioner and VP, Personal Financial Services at Bank of Bermuda. She holds a NASD Series 7 license, and formerly owned a US financial services practice meeting the needs of 400 individual and corporate clients.

Confidential Email can be directed to marthamyron@northrock.bm

The article expresses the opinion of the author alone, and not necessarily that of Bank of Bermuda. Under no circumstances is this advice to be taken as a recommendation to buy or sell investment products or as a promotion for financial plans. The Editor of the Royal Gazette has final right of approval over headlines, content, and length/brevity of article.