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Chapter 2

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Economics (Arts)
ECON 208
Wendy Dickinson

02_raga_ch02_topic_02.qxd 3/25/10 9:27 AM Page 1 WHAT THE S&P/TSX REALLY MEASURES 1 What the S&P/TSX Really Measures In Chapter 2 of the textbook we explain the meaning and construction of i ndex num- bers. The examples we discussed were index numbers for the output of news print and steel. Both were relatively simple index numbers because each one showed the move- ment of just a single variable over time—the quantity produced of some commodity. We also talked briefly about more complex index numbers, ones that show the move- ment of an average of several variables. A well-known example of such a complex index number is theConsumer Price Index(CPI), an index number showing the change in the average price of the many goods and services purchased by typical consumers. The CPI is more complex than the steel and newsprint index numbers that w e examine in Chapter 2 because it is necessary to first compute the average price of the typical consumer’s basket of goods and services. A simple average does not suffice; instead, it is necessary to compute a weighted average, where the weight used for each individual good or service reflects the importance, in dollar value, of that specific d- uct in the consumer’s overall purchases. Products that represent a very small share of consumers’ total expenditure, like sardines or toothpicks, will have a very small weight in the CPI. In contrast, items that represent large expenditures, like soline and hous- ing, will have much larger weights. Another complex index number that is very well known in Canada is the S&P /TSX index. Here we explain what this index is, how it is constructed, and how to interpret its fluctuations. What Is the S&P/TSX? When you hear people talk about changes in the “S&P/TSX,” they are referring to what is properly called the S&P/TSX Composite Index. This is an index number designed to measure changes in the dollar value of the companies that hav e their stocks listed (and traded) on the Toronto Stock Exchange. Like all index numbers, it has a base year; the index takes a value of 1000 in its base year, which was 1977. Over three decades later, in June 2009, the S&P/TSX fluctuated between 10 000 and 10 500. A “good day” (for those people who own the shares) occurs when the index rises by 100 or 200 points. A “bad day” sees a decline of the same amount. But t he index is quite volatile from day to day, and so most people place little importance on daily fluctua- tions; a daily change of 50 or 75 points, in either direction, is very mmon. Not all stocks traded on the Toronto Stock Exchange (TSE) are represented in the S&P/TSX Composite Index. The companies’ stocks included in the index c ompose more than 70 percent of the total market capitalization of all the compan ies traded on the TSE. (The market capitalization for each company is equal to its sha re price times the number of its outstanding shares.) Furthermore, the companies that a re included are drawn from many different industries. So even though not every company is included i n the S&P/TSX index, changes in the index are widely viewed as representing changes in overall stock-market values. As a result, when people speak of what “t he market” is doing today, they are rarely referring to the behaviour of individual stock prices; instead, they are referring to the change in this broad index of stock-ma rket values. Note also that the S&P/TSX is not a price index like the Consumer Price Index—it is a value index. In other words, it does not measure the change in the average stoc k price; instead, it measures the change in average market value, or market capitalization. However, since any firm’s market capitalization is equal to that firm’s share price times Ragan and Lipsey, Economics,13th Canadian Edition Copyright © 2011 Pearson Canada Inc. 02_raga_ch02_topic_02.qxd 3/25/10 9:27 AM Page 2 2 WHAT THE S&P/TSX REALLY MEASURES the number of its outstanding shares, it follows that changes in the share’s price lead to a change in that firm’s market value if the number of outstanding shares does not change. On most days, the number of outstanding shares for any specific firm is not chang- ing, so fluctuations in its share price directly cause changes in its market capi talization. A 3-percent increase inthe share price will result in a 3-percent increase in the firm’s market capitalization. But occasionally firms will either issue new shares or buy back some of their existing shares, and such changes in the number of outstanding shar es imply that we cannot always identify changes in the S&P/TSX index with changes in av erage stock prices. Keep in mind that the S&P/TSX Composite Index measures the change in the average market valueof the various companies that it includes. How Is the S&P/TSX Constructed? The S&P/TSX Composite Index is constructed and published by Standard & Po or’s, a company with a long history of providing financial-market analysis and se rvices. The S&P Canadian Index Committee is a group of people within Standard & Poor’ s that operates the S&P/TSX Composite Index. It has established guidelines for m aintaining the index. Which companies are represented in the index, and which ones are not? Fou r condi- tions must be satisfied in order for a company to be included. First, the company’s stock must be listed on the Toronto Stock Exchange (which, in turn, requires that the company issuing the stock satisfies specific regulatory requirements regarding it s method of accounting and reporting, as well as other details). Second, the company must be incor- porated in Canada. Third, the company’s “float” market capitalization must exceed $250 million, where the float market capitalization is the company’s total market capi- talization minus the value of those shares held by blocks that control 20 percent or more of the stock. Fourth, the stock must be actively and regularly traded in order to be included in the index; in other words, the stock must be sufficiently liquid. The composition of the S&P/TSX index is reviewed every quarter by the com mit- tee, when some firms are added to the index and others are removed. Once a company no longer satisfies the four conditions listed above, it is removed from the index. Simi- larly, after a company newly satisfies the four conditions (based on data fro m the pre- vious year), its stock is added to the index. With this regular and frequent renewal, the committee ensures that the S&P/TSX Composite Index provides an accurate r epresen- tation of the average stock-market values of the largest firms traded on the TSE. As of December 31, 2008, the stocks of 220 companies were represented in the S&P/TSX index, with a combined market capitalization of $941 billion. (J ust for com- parison purposes, note that Canadian national income in that year was $16 00 billion.) The average market capitalization among the represented firms was $4.3 bi llion, with the largest being $50.5 billion (Royal Bank of Canada). Table 1 shows the companies that are most heavily represented in the S&P/ TSX index—the firms whose market values enter the index with the largest w eight. The weights on the various firms add up to 1, and each weight represents that firm’s share in the total market capitalization of all firms represented in the index. For exam- ple, the weight of 5.36 percent for the Royal Bank is equal to its fracti on of the com- bined market capitalization of all the firms included in the S&P/TSX Comp osite Index. 1 1Note that with changes in firms’ market capitalization, th esented in the top ten list change over time. Five of the firms listed in Table 1 werenot among the top
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