The media has been abuzz over recent weeks, with the apparent news that the New Zealand Stock Market is hovering at record levels. However, although a bull run is indeed in full swing, it is a little premature to begin rewriting the record books. Watermarking a market high based on the widely quoted NZX50 Gross Index does not make sense and prevents sensible historical comparisons.
A fair understanding of the underlying market value of the share market is important because it helps give us an indication of investors’ expectations of future corporate profitability in the economy. In New Zealand, the media and analysts alike tend to talk about the NZX50 Gross Index when assessing where the value of the New Zealand Stock Market is relative to its historical levels.
The Gross Index measures the value of New Zealand’s 50 largest and most liquid stocks by considering the underlying market prices of each stock and assuming that all dividend payments are immediately reinvested across the portfolio. The alternative would be to discuss the NZX50 Capital Index, which only captures underlying market prices of these top 50 stocks.
The tendency to discuss the NZX50 Gross Index in favour of the Capital Index is propagated by NZX, the operator of the New Zealand Stock Market. NZX argue that analysing changes in the Capital Index significantly understates share market performance in New Zealand because stocks here offer an unusually high dividend yield – the highest in the developed world. As a result, not only should people measure performance using the NZX50 Gross Index, but in order to make fair comparisons with international market returns, NZX also advocates using similar gross or return indices for those markets.
Although I agree that there is a clear advantage to using changes in the NZX50 Gross Index for measuring returns, we shouldn’t completely bag the NZX50 Capital Index just yet. Brian Gaynor correctly pointed out in his NZ Herald column a couple of weeks ago that the Capital Index is still the more appropriate starting point when measuring a record share market high. Unfortunately this point is frequently overlooked by many commentators who insist on also using the Gross Index for this purpose.
Measuring a share market high, or the value of the market relative to its value at a previous point in time, is quite a distinct concept from measuring the total returns that a shareholder would have made between two points in time. A Gross Index is not an appropriate measure of value, as it includes an arbitrary assumption that all shareholders always immediately reinvest each dividend payment. This assumption is clearly false in practise – it is merely used as a way of estimating total returns to shareholders over a defined holding period.
When considering a share market high, we need to look at a measure that reflects the total market capitalisation of each company on the market– this is precisely what the NZX50 Capital Index shows. Whenever we look at the Capital Index, we are given a snapshot of the prices that people are paying for shares on the share market on a given day. If we find the highest point in the Capital Index, we have located a record market high in nominal terms.
The NZX50 Capital index closed at 2436 yesterday, still some 26% in nominal terms below its recent peak of 3296 in May 2007 before the Global Financial Crisis. If we decide to factor changes in purchasing power into the equation, the Capital Index is just over 35% below its May 2007 level. Nevertheless, the share market has still rallied significantly over the past year, with the Capital Index having risen 19% in nominal terms and, factoring dividends into the equation, the Gross Index shows returns of some 24%.
These distinctions may seem a little abstract to some, but consider applying these types of concepts to the housing market. If we were assessing whether nominal house prices are at a record level, then we could form some kind of capital index based on average house prices through time. However, if we wanted to see the total returns an average landlord made over a given year, we would need to consider the landlords’ profits from renting out property, as well as changes to our capital index over that year. This second method of calculating returns is mathematically identical to if we had formed a gross index and looked at changes in the index between two points in time.
It may seem funny that these concepts are constantly being muddled when considering the share market. However, bear in mind that it is not in the interests of NZX to speak out otherwise. Many people will judge NZX by how its markets are performing and if markets appear to be breaking records, then this suits NZX just fine.
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