Mirror Risk in Benchmarks

Mirror Risk in Benchmarks
by John A. Prestbo

While only the naïve would confuse a country's stock market with its economy, it is commonly acceptable to use the stock market as a rough, daily indicator of economic trends. A rising market typically occurs when economic conditions are strengthening, after all, and a falling market tends to reflect or anticipate decelerating economic growth.

The relationship is not highly calibrated, however. Consider the accompanying chart of Canadian economic growth (bars) and the stock market (line) over much of the past decade. Though the stock market is said to look ahead, it certainly didn't seem to foresee in 1993 the 4.5% growth that occurred in 1994. The stock market compensated for this shortcoming by rising substantially in 1996, even though economic growth slowed considerably from the previous year.

One reason for this disconnection is that the Canadian stock market isn't a mirror image of the Canadian economy. That's true for every country in the world, even the United States, where technology, for example, commands roughly a third of stock market valuation but accounts for perhaps 10% to 12% of gross domestic product (GDP). By the time you get to stock indexes, which in many cases consist of only a portion of the stocks available in the market, the reflection of the economy can become highly distorted.

This "mirror risk" may seem subtle at first glance. But it's important for pension plans, which are in the investment game solely to pay off future liabilities. The values of pension plans' future liabilities grow faster or slower depending on government and plan policies, demographic trends and--most of all--economic growth.

Using the 10 sectors in the Dow Jones Indexes corporate classification system, the Consumer, Cyclical sector looms large in the Canadian economy, in part because of all the automobile and auto-related manufacturing in southern Ontario, but little of the sector shows up in the Canadian stock market.

The TSE 300 and the new Dow Jones Canada Total Market Index (covering a constant 95% of the investable market in Canada), have sector structures that in some instances deviate considerably from that of the economy. Technology is the most egregious distortion, of course, accounting for 35% or more of the stock market and only 3% of the GDP. Much of that distortion is due to one stock, Nortel Networks, which is a problem unto itself for Canadian institutional investors.

The sector-by-sector chart shows most clearly where the "mirror risk" lies in Canada. Sectors that loom larger in the economy than in the TSE 300 composite index are Consumer, Cyclical, Healthcare and Industrial. Sectors bigger in stocks than economic activity are Energy, Telecommunications and Technology. Four sectors are matched closely enough between market and economy to constitute minor "mirror risk": Basic Materials, Consumer, Non-cyclical, Financial and Utilities.

Managing mirror risk
Generally, benchmark indexes with a fixed number of components are more vulnerable to "mirror risk" because they have less flexibility to adjust to market dynamics and, by extension, changes in economic structure. Less vulnerable are benchmarks that maintain consistent coverage rather than component numbers because they are unconstrained in correcting their reflections as time passes.

Sector investing is beginning to become more popular with portfolio managers because it is a perspective that works well on national, regional and global scales. Active Canadian managers can underweight and/or overweight appropriate sectors on either a national or an international basis. Some already do this, though the goal almost always is to enhance performance. Depending on their mandate, their goal could be to adjust their portfolios to correlate more closely with the drivers of the economy that are influencing their employers' liability scenarios.

John A. Prestbo is editor of Dow Jones Indexes.

Contex Group