This article discusses some of the major stock indexes in the US including their history and relevance to today's investors. Stock indexes, or stock market indexes, are lists of stocks and statistics that reflect the composite value. Broad-based indexes such as the Dow Jones Industrial Average or the S&P 500 in the US are representative of the performance of the entire market. For this reason, these indexes are closely watched as a reflection of how investors view the state of the economy. Specialized indexes allow investors to track portfolios for specific sectors of the overall market which are much more manageable. Specialized indexes track performance of stock portfolios that are grouped by common attributes such as market or size of company. This essay discusses some of the major broad-based indexes and current trends surrounding the use of traditional indexes. Stakeholder issues are discussed from the standpoint of what current stock indexes provide for managers, investors and policy makers. A new generation of stock indexes is emerging to meet additional stakeholder demands and these are discussed along with other emerging trends in the use and creation of stock indices.
There is no perfect stock index. Indexes are developed to gauge performance of groups of stocks. As the proliferation of stocks increases in our global economy, the greater the need to develop new indexes that help stakeholders to monitor performance of certain stock segments.
Dow Jones Industrial S&P Mid Cap Standard and Poor's S&P Small Cap Nasdaq Composite Russell 3000 Nasdaq 100 Russell 2000 Wilshire 5000 Russell 1000
The Dow Jones Industrial Average (DJIA) index was started in 1896 by Charles Dow and indexed 11 stocks at its inception. Today, the DJIA tracks 30 stocks that are known as "blue-chip" stocks. The "blue-chip" companies that are indexed in the DJIA are considered industry leaders in a variety of segments including: Energy, banking communications, retail and entertainment.
Methods for Stock Indexing
The Dow indexes its stocks using a price-weighted system. Price-weighted indexing means that the total prices of all stock are added together and divided by the number of stocks in the index. Market capitalization is the method of indexing used by many of the other major indexes such as the NASDAQ and S&P 500. Market capitalization takes into account total market value and not just price. Market capitalization is felt by many to be a better indicator of overall market performance. The other major criticism of the Dow is that because it only tracks 30 stocks (out of the thousands of stocks on the market), it isn't considered very representative of the market as a whole.
NASDAQ, Standard and Poor's 500
The NASDAQ index was started in 1971 and is a market-weighted index that tracks a large number of technology stocks (sometimes referred to as "tech heavy"). The NASDAQ does track over 5000 technology related stocks and as such, is a good representation of stocks from the tech sector. However, the NASDAQ doesn't do as good a job of indicating the markets as a whole. Other drawbacks cited for the NASDAQ are that the index includes a number of small companies that tend to increase volatility in the market.
Standard and Poor's 500
Another major stock index is the Standard and Poor's 500 (S&P 500) which indexes "large cap" companies. These companies have market capitalization of over $10 billion as calculated by the companies number of shares multiplied by the stock price. It's important to remember that stock prices change over time and therefore the companies referenced in the index may also change. The "large cap" or "big movers" are indicative of company size (Wayman, 2007).
The Wilshire 5000 is considered the "total market index"; it was started in 1974 by Wilshire Associates. The index came about due to the availability of computer technology that allowed for efficient indexing of large amounts of statistical data. The Wilshire has been called the "nation's broadest-based index" and is thought by many to be the most accurate reflection of the overall market. The index now includes stocks from 6700+ firms (essentially every public firm and is therefore highly representative of the overall market)-not the 5000 that are stated in the index name. The Wilshire is not often cited in the financial press because the index is considered by many to offer "too broad" a view of the US markets. The Wilshire is so diverse that it is not easy to tell which sectors are moving the market (ex: tech, industrial, small or large).
The Dow Jones, NASDAQ, S&P 500 and Wilshire indexes are just a representative four out of the hundreds of stock indexes that are now available to benchmark stock performance. The first three (DJIA, NASDAQ & S&P) are very visible, broad-based indexes and as such, are often cited for financial reporting purposes as good indicators of investor confidence in the US economy. Current literature indicates that stakeholders such as money managers, clients/investors and policy makers need to monitor other indexes to make sound decisions about stock market investments and to meet their respective objectives. There is no consensus from stakeholders about which index is best; all have benefits and drawbacks. Investors and fund managers are continuously on the lookout for new and better designed indexes that will help to monitor investment portfolios.
Evaluations of Stock Indexes
By definition, a stock index is a representative sample or snapshot of stocks that is a subset of the larger universe of stocks. There are literally hundreds of stock indexes available for the individual investor or market fund manager to monitor on a daily basis. Yet, even with the proliferation of indexes, the big three (Dow Jones Industrial Average, S&P 500 and NASDAQ Composite) "rule the headlines" and serve as the major sources of stock market analysis for most investors and managers (Wayman, 2007). There is plenty of criticism in the industry and media about the shortcomings of the major US indices in their ability to provide real insight into many markets.
Pros of the Major US Indices
The DJIA, S&P and NASDAQ indexes are useful tools for tracking market trends and historical perspectives. Investors who look at how indexes react to economic trends over time will have a better understanding of why trends occur. These indexes can be useful tools for helping investors make better investment decisions.
Cons of the Major US Indices
The major US indexes are subject to calculation bias. Most indexes (with the exception of DJIA) are market-weighted indexes. This simply means that stocks of larger companies with larger market presence have a larger influence on the index. Large stocks influence the index much more than small companies (with smaller market share-market cap). Many feel that if the index is weighted toward large company stocks, the index can't really describe the health of the overall index. This over-weighing means that if the "big dog" is sick, the whole "market" gets the flu, regardless of the strength of the smaller stocks that are in the index (Wayman, 2007). A more equally weighted index would be more democratic and do a better job of capturing the impact of smaller stocks that may be rising but ignored due to scrutiny of larger companies.
The stocks that are included on indexes are picked by committees who do their best to choose stocks that reflect the economy in a given year. Committees generally meet on a yearly basis to re-define the stocks to be included on the index. Because the stocks included in a given index change over time, one cannot assume that the index will reveal trading patterns of the same stocks over a long period of time. Another challenge for many is the knowledge that indexes are not as dynamic as the market itself. For this reason, some critics state that the indexes don't always reflect where growth will be in the market.
Stock Market Fluctuations
Market "Crashes" & their Causes
Stock market indexes are often quoted in the media as barometers of the overall health and vitality of the economy. Many stakeholders, including policy makers and individual investors pay close attention to daily fluctuations reported by the market indexes. There have been a number of documented "crashes" in the last several decades, and investors and indexes almost always tend to react to them in similar ways. The following is a timeline of "market crashes" and the related event that caused the reaction (Marcial, 2007):
- 1973 Oil Embargo
- 1987 Double-Digit Interest Scare
- 1998 Russian Debt Default
- 2000 Dotcom Bust
- 9/2001 Terrorist Attacks in US
- 2/2007 Chinese Market Trouble
- 8/2007 Sub-Prime Mortgage Scare
- 5/2010 "Flash Crash" High Frequency Trades Triggered by Single Large Sell
- 8/2011 Downgrading of U.S Credit Rating and European Sovereign Debt Crisis
Domestic Issues Affecting Stock Indexes
Stock market indexes are highly susceptible to pivotal events as indicated by the above list. Credit trouble in the US in 2007 has been a dominant theme throughout the year and has caused speculation that similar ills could spread into the global economy. The now-famous sub-prime mortgage troubles in the US are the type of issue that puts stock markets on high alert....
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