Stock Market Indexes

Investment Snapshot

* The Dow Jones Industrial Average increased by 212 points on one day of trading, indicating stock market euphoria.
* In July 1998, the Nasdaq Composite Index reached 5,000, and eight years later, the index hovered around the 2,000 level.
* Citigroup has developed a market sentiment index model that indicates whether stock market investors are euphoric or in a state of panic

The stock market indexes are viewed as the vital signs for predicting the direction of the stock market. Not only do the stock market indexes influence the investment behaviors of individual investors, but they also influence the investment decisions of investment professionals (fund managers).

RETURNS AS MEASURED BY THE STOCK MARKET INDEXES

A number of stock market indexes give you different measures of the stock market. You can use these indexes in the following ways:
1. To determine how the stock markets are doing
2. As comparison benchmarks for the performance of your individual portfolios, mutual funds, and exchange-traded funds
3. As forecasting tools for future trends

These market indexes give you a glimpse into the movement of individual stock prices. However, you should understand the relationship between the indexes and individual stocks before taking any action. In general, the different stock market indexes move up and down together by greater or lesser amounts, although they sometimes diverge. Figure 6–1 presents a comparison of the three major stock market indexes. These differences are due to the composition of stocks in each index, the manner in which each index is calculated, and the weights assigned to each stock.

An aggregate measure of the market is calculated as an average or an index. An average is calculated by adding stock prices and then dividing by a weighted number to give an average price. An index is a weighting of stock prices related to a base year’s stock prices. Examples are the Standard & Poor’s (S&P) 500 Composite Index, the New York Stock Exchange Composite Index, and the OTC Index (over-the-counter stocks).

Figure 6-1
Comparison of Market Indexes, 1988–2005


The relative weighting of the individual stocks in each index differs. A price-weighted index is composed by adding the share price of each stock in the index and then dividing by a number that is adjusted for stock splits. The Dow Jones Industrial Average is calculated on a price-weighted average. A market-value-weighted index is compiled using the market value of each company in the index. The weighting of each company is determined by its market capitalization, which is the market price of the stock multiplied by the number of shares outstanding. Consequently, a company with a larger market capitalization will have a greater weighting in the index. Stock splits do not affect the index. The S&P 500 Index is a market-value-weighted index.

An equally weighted index is computed by giving each stock the same weight regardless of price or market capitalization. The equal-weighting method places an equal dollar value on each stock, in contrast to price weighting, which uses an equal number of shares of each stock, and market-value weighting, which views stocks in proportion to their market capitalization. An equally weighted index can be calculated using an arithmetic or geometric method. The Value Line Index uses the geometric method.

These differences explain the discrepancies between the rates of return of the different indexes. Following is a discussion of the most widely used stock indexes.

KEY CONCEPTS
* Returns as measured by stock market indexes
* Determining which index to use in evaluating your portfolio
* The importance of stock market indexes

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