Relative Performance: Equal or Market Capitalization Weighted Index?

Using SCHA and SCHX as proxies for Small and Large cap equity markets, I attempt to measure cumulative relative performance over one (1), two (2), and three (3) year time periods.

The S&P 500 is a market capitalization weighted index, meaning the biggest companies have the biggest weights in the index. The Dow Jones Industrial Average (DJIA) is a price weighted index. So companies with large stock prices are weighted heavier. (Example: Goldman Sachs at $230 has much more weight than Intel at $34). There are also equal weight indexes (Ticker: RSP). These weight each stock in the index equally, regardless of price or market cap. (Ex: 60 stocks, each gets 1/60th weighting.)

Investing your money in a market cap weighted index leaves you relatively more exposed to larger companies, where equally weighted indexes leave you more exposed to smaller caps. Price weighted indexes have very little mathematical basis, other than they’re easy to understand. Price weighted indexes are not good representation of changes in value of the stock market, thus we ignore them in this exercise.

Small cap stocks tend to exhibit more price movement, i.e. more volatility. More risk, more reward. On average, small caps will outperform in a bull market, but under-perform in a bear market. The strategy goes, overweight small caps when times are good, overweight large cap value (Walmart, Walgreens) when times go sour.

Here’s the relative cumulative performance of Small/Large Cap equities. A number above one (1) means small cap is outperforming, while a number less than one (1) means Large Caps are outperforming.

rp_largesmall

 

The above graph shows relative cumulative performance starting in March of each year. Example, blue line shows 36 month relative cumulative returns, while the green line shows the 12 month relative cumulative returns.

Since Trump took office in November of last year, we’ve seen a bump in small caps, then a subsequent sell off, relative to large caps. Small caps popped first, then large caps followed. However, small caps have outperformed relatively since last year, while large caps have performed better since three (3) years ago.

We need to compare this to an average ratio for each time period (far right column). Note: these are weekly returns (March thru March).

smalllargetable

Large Cap have outperformed Small Cap over the last three years, pretty significantly, and under-performed over the last twelve (12) months.Thus, equal weight has outperformed over the past year as we see below. However, Large caps have made a *Huge* rally relative to small caps since February. Here we used RSP and SPY as proxies for equal and market weighted indexes.

rp_eq_mkt

Strategy: Large Caps were over valued last March, but Small cap valuations are catching back up. Buy equal weight for the 6-9 month time period, then re-evaluate relative performance. Note: Tax reform will help Small cap over Large cap, so watch for tax reform in late summer,early fall (LINK, Fortune).

Disclaimer: this article is designed to help you choose between Equal or Market cap weighted indexes; I’m not advocating specific securities. This is only one measure of relative valuation, do more research on your own before purchasing securities. I do own SCHA.

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Supersize Me’s Effect on MCD’s Stock Price

Image result for mcd

I’ll save you the suspense: MCD’s stock price returns were affected by the release of Morgan Spurlock’s Supersize Me on May 7, 2004. However, MCD’s stock price returns were also unaffected by the release of Morgan Spurlock’s Supersize Me when measured differently.

If you just change how you measure the reaction, you can get the data to tell you what you want. In the business it’s called confirmation bias or data mining. The desire to produce a positive result incentivizes researchers to get the numbers to tell them what they want to hear.

In the example of McDonald’s stock price, we use an event study to gauge the average change in stock price before and after the ‘event’. Morgan Spurlock’s Supersize Me didn’t portray McDonald’s fares in the most appealing light, so I expected to find a negative change in the returns and volume of McDonalds stock, all else held constant.

Quick stats refresher:  A big t-stat implies rejection of the null hypothesis, in favor of the tested hypothesis. A small p-value implies significance. A p-value ranges from [0,1] with zero being the most significant and one being the least.

Using a simple t-test to compare average daily returns here’s my results:

Screen Shot 2017-03-08 at 4.51.39 PM.png

A small p-value, as we see above, implies significance. This means the average return on MCD’s stock was significantly different before and after the release of Supersize me! But check this out…

Screen Shot 2017-03-08 at 4.51.32 PM.png

Over the same time period, but at a weekly tenor, we see a different result. This p-value is huge, the average weekly returns were not significantly different from one another before and after the release of Supersize me.

 

Screen Shot 2017-03-08 at 4.49.49 PM.pngScreen Shot 2017-03-08 at 4.50.19 PM.png

This exercise goes to show you should be wary and inquisitive if a statistic doesn’t make sense or makes too much sense. The financial world is not a laboratory where everything works out the way it “should” according to the models. Statistical findings are useful tools to model and describe our world, but always take them with a grain of sand. (I’m never sure if its sand or salt…)

Challenge ideas, be inquisitive, and don’t get all your news in one place.

Thanks for reading,

-tommander-in-chief

Note 1: If you want the data, I’ll be happy to provide it.

Note 2: Time Period (Jan. 1, 2004 – Sept. 20, 2004)

Side note: Risk is a human made concept. If you can associate a probability with an uncertainty, you’ve created risk. If you can’t calculate a probability that an event will occur it remains an uncertainty, and is either over or underestimated depending on your past experiences. For example: you hear about a recent shark attack on the news and are planning a day at the beach. Because of immediately available information, you overestimate the probability that you’ll be attacked by the shark and spend the day building sandcastles rather than shredding the surf. The risks don’t match up.Your perceived risk and the probability that you’ll be gobbled up by a Great White are different.