Monitoring the Markets: What Indexes Tell Us
By Kyle Tetting
Each week, we open our “Money Talk with Bob Landaas” webcast with a review of the latest developments on Wall Street and end-of-the-week updates on a few benchmark indexes.
Additionally, we regularly field calls from interested investors who want to know what the market is doing for the day, the month or the year. Most of these investors have heard of the Dow, the S&P and the Nasdaq and can tell you day-to-day which is up or down, but they may not know the differences between them.
While the Dow, S&P and the Nasdaq are most common, there is an index for just about every area of the stock and bond market, which serve as a benchmark for that market’s current condition.
Dow Jones Industrial Average. Often referred to as just the Dow, it is probably the most quoted financial barometer in the world, with many observers using its movements to gauge directions in the stock market.
Charles Dow’s initial stock average, containing 11 companies (including nine railroads) first appeared in the precursor to the Wall Street Journal, Customer’s Afternoon Letter, in July 1884. In February 1885, the list added three more railroads. It was not until May 1896 that the Dow Jones Industrial Average appeared in the Wall Street Journal, containing the stocks 0f 12 strictly industrial companies. The original 12 were meant to represent the major market players of that time.
Of the original 12 Dow industrials from 1885, only General Electric remains.
The other 11:
- American Cotton Oil
- American Sugar
- American Tobacco
- Chicago Gas
- Distilling & Cattle Feeding
- Laclede Gas
- National Lead
- North American
- Tennessee Coal and Iron
- U.S. Leather pfd.
In 1929, the index expanded to 30 stocks and has been continuously updated to reflect the major players in our ever-changing economy. Today’s Dow represents 30 of the most highly capitalized and influential companies in the U.S. economy.
While some argue that an index of only 30 companies hardly reflects the state of the market, a quick comparison of the Dow to many broader market measures, such as the S&P or the broadest of them all, the Wilshire 5000, shows a clear correlation between the Dow and the U.S. stock market. As a result, the Dow is a good starting point for measuring the stock market.
Another domestic stock index, from Standard & Poor’s – the S&P 500 – looks at 500 companies of comparable size and economic importance to the Dow’s list of 30. Given its larger sample, the S&P has replaced the Dow for some investors as a more accurate representation of the market and the risk/return characteristics of U.S. companies with large market capitalizations (measured by share price multiplied by number of shares outstanding).
The Wilshire 5000 Total Market Index is meant to represent the entire U.S. equity market by measuring the performance of all companies with readily available price data. It takes into account companies of all sizes, unlike the S&P 500 and the Dow, which focus primarily on the large-cap arena.
Care to guess how many companies are in the Wilshire 5000? At last check, it was made up of 6,703 companies, but “The Wilshire 6703” doesn’t have the same zing to it. The index hasn’t changed names since it was first established with 5,000.
One other major and oft-quoted index is the Nasdaq, named for the National Association of Securities Dealers Automated Quotations system. The Nasdaq grew in fame during the technology boom and subsequent bust, given that it consisted of many tech stocks. But there’s more to the Nasdaq than just tech stocks. In fact, it is made up of every stock and other investment that trades on the Nasdaq system, meaning it is not limited to companies with U.S. headquarters. The Nasdaq system includes a good number of technology-based companies, but it also includes American Depositary Receipts and Real Estate Investment Trusts. Because of the composition and number of stocks, the Nasdaq fluctuates regularly.
In addition to these major indexes, there are hundreds of others out there that represent every imaginable area of stock or bond investing. These are often meant to measure a specific area or capitalization – like the MSCI Emerging Markets Index or the Russell 2000, an index of small-cap stocks. Often, indexes carry the name of the company or agency that sponsors them – and subsequently profits from their use.
Dow Jones, has created a number of other indexes, including the Global Dow, meant as a measurement of stocks around the world. The Global Dow comprises companies with a long history of success and wide following among investors. As the name implies, the Global Dow tracks companies from around the world and often with a global reach. It covers all types and sizes of markets and sectors and includes emerging markets such as Brazil, India and China as well as emerging sectors, such as alternative energy.
It is important to note what the index being quoted represents in terms of company size and location. It is equally important to note how the index is weighted, how much significance it gives to each of its components.
Essentially, there are two different approaches. The Dow uses a price-weighted index, meaning that a stock influences the index in proportion to its price per share.
Most other major indexes – including the S&P, Nasdaq and Wilshire – weigh component stocks based on capitalization, which is a result of both share price and number of shares outstanding. Using this method, the larger the capitalization of a company, the greater its influence on the index.
Some argue that overweighting larger companies distorts an index’s view of the market, but it should be noted that larger companies also have a larger shareholder base, making a case for higher relevancy in the index.
With a little knowledge on the composition and weighting of the various indexes, we can understand the differences between them and in what ways they might reflect on the overall state of the market.
In addition, by playing on the subtle differences, we can draw parallels and distinctions between areas of a marketplace broader than any one index. With so many different types of investments, the different indexes give us the ability to gauge the state of many different areas of investing. Additionally, we can try to use the knowledge of the various indexes to identify areas we believe represent opportunity and invest accordingly.
Kyle Tetting is director of research at Landaas & Company.
initially posted May 4, 2010; revised March 18, 2015
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