Wall Street Steward Blog

What Index You Talking Bout??!

Hey Matt, what is the market doing today?  What do you think the market will do next year?  Why is the stock market going up?  Should I just buy the market and be done with it?

These are the types of questions that a financial genius advisor faces every day.  As much as my sarcastic alter-ego wants to answer “What is the market doing today?” with “FLUCTUATING,” I usually follow up with a question of my own.

What market are you referring to?

What I am really asking is which index do THEY use to gauge the stock market?  The reason this is important is each index has its advantages and disadvantages…its pros and cons if you will.  Class, please find a seat and let us begin today’s lesson.

The Dow, as they call it (whoever T H E Y are), is a stock market index made up of 30 of the world’s largest, most actively traded stocks.  It was founded by Charles Dow, who clearly had the same name choosing ability as former Charlotte BOBcats owner, Bob Johnson

The companies contained in this index are household names – as soon as someone hears them, they instantly know who the company is and what they do.  Don’t believe me?  Want to play?  What comes to mind when you hear:  GE?  McDonald’s?  Wal-Mart?  You get the picture

I am not sure why this index was anointed as “the market” because I do not feel it is a great indicator of overall strength in the stock market.  Some would say that if the “blue chips” are doing well, then the overall stock market must also be strong, right?  Not exactly.  WHY?  I thought you would never ask.

There are two major limitations that prevent the Dow from being a strong market indicator:  (I) it contains only 30 stocks, whereas many other indices include hundreds of stocks and (II) it is a PRICE WEIGHTED index, which means that the more expensive stocks count more in the performance then the cheaper ones.  As of this writing, Wal-Mart (WMT) is priced around $55 per share, while 3M (MMM) is trading around $84 per share.  This means that a $1 move in 3M will have a larger impact on the Dow Jones Index than a $1 move in Wal-Mart. 

S&P 500
The Standard and Poors 500 index is comprised of 500 of the largest companies in the U.S. as measured by market capitalization.  This is where S I Z E matters, as opposed to….err…nevermind.  The larger a company is, the more it counts in this index, and although using 500 companies is a better barometer then using only 30, it also has some downside.  Bigger isn’t always better…or so I have been telling myself for the past 15 years.  Allow me to elaborate. 

Imagine if the wealthiest 10% of the people in your state all pooled their money together and decided to back a certain candidate for Governor.  Would it really matter what the other 90% of the residents wanted?  This is a similar phenomenon to that of the S&P 500.

The top 50 stocks in the S&P 500 have a larger significance in the performance of the index than the other 450.  Even a more severe stat is that almost 19% of the index is contained in the top 10 holdings .  So, as those top 10 stocks go, the S&P 500 goes…most of the time anyway.

The S&P 500 is a good index to use as a benchmark (better then the Dow), but because it is cap-weighted and contains mostly LARGE domestic companies, I think there are better ones out there.

Russell 1000
This index cherry-picks the largest 1000 companies out of the Russell 3000 index.  Again, it represents mainly large companies and is cap-weighted, but because it contains 1,000 companies, is still a decent indicator.  Imagine if the S&P 500 had 1,000 companies in it…then it would be nearly identical to the Russell 1000. 

Russell 3000
The R3K (sorry, couldn’t resist) measures the performance of 3,000 publicly held companies, which represents 98% of the investable U.S. market

Now we are talking!  Amongst the contenders, this index would get my vote as the best barometer of the overall stock market.  It includes large-cap stocks, mid-cap stocks , and small-cap stocks.

Depending on which type of exposure you are seeking, or what type of investment you are looking to compare to a certain index, chances are there is a “best fit” option for you.  In the interest of bandwidth usage and usage of your time, I won’t get into every index under the sun.  I will touch on a few more briefly though, just in case your favorite was left out.

NASDAQ:  over 3,000 components, but very technology heavy
Barclays Aggregate Bond Index:  most widely followed bond market index
EAFE:  acronym for “Europe, Asia, Far East,” most common international index

So, the next time you hear someone comment on “the market,” I hope you can intelligently question them about which index they are referring to.  Understanding how each index is handicapped can go a long way to better understanding your investments.

Creative Commons License photo credit: pfala

The Dow Jones Industrial Average is compromised of 30 stocks that are major factors in their industries, and widely held by individuals and institutional investors.  The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.  The Russell 1000 Index consists of the 1,000 largest securities in the Russell 3000 Index, which represents approximately 90% of the total market capitalization of the Russell 3000 Index. It is a large-cap, market-oriented index and is highly correlated with the S&P 500 Index.  The Russell 3000 Growth Index is an unmanaged index comprised of those Russell 3000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 3000 Value Index measures the performance of those Russell 3000 companies with lower price-to-book ratios and lower forecasted growth values.  The Barclays Capital Aggregate Bond Index is an unmanaged market capitalization-weighted index of most intermediate term U.S. traded investment grade, fixed rate, non-convertible and taxable bond market securities including government agency, corporate, mortgage-backed and some foreign bonds.