Stock Market Indexes
What are they? What do they do?
Indices: What are They?
• An index takes a small cross-section of a larger
population as an indicator for that larger
population.
• It accomplishes the same thing as an election
poll… asking a few voters in order to get an
indication of the larger masses.
Indices: What are They?
• An index thus is a representation of the market as
a whole.
• Indexes may be very broad, virtually covering the
entire market, or very narrow, measuring a small
sector of the economy such as oil drilling stocks.
Indices: Terminology
Before going further, in order to understand the
indices, you need to understand the term
capitalization.
Capitalization is a way to measure the size of a
company.
Indices: Capitalization
Capitalization (aka “Cap”)
= # of shares outstanding x price per share
Stocks are often segregated and referred to by their
capitalization, such as Large Cap, Mid Cap, Small
Cap, Micro Cap
Indices: Capitalization
Generally speaking…
Older companies with high share prices - such as IBM,
Microsoft, GE, and Exxon – would fall into the large cap
arena.
Less well-known companies would fall into the small-cap
arena.
Indices: How many are there?
• There are hundreds of indices from the very broad,
to the narrow
• There are 7 major indices that we will study
The Major Indices
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Dow Jones Industrial Average (DJIA)
S&P 500
Russell 2000
S&P 400
NASDAQ Composite
Wilshire 5000
Value Line Geometric Index
Index vs. Exchange
Many beginning investors confuse exchanges with
indexes. The exchange is the location at which
the stock is traded, whereas the index is simply a
representation of a segment of the stock market.
Index vs. Exchange
For example, IBM trades on the New York Stock
Exchange, but is part of several indexes such as
the…
Wilshire 5000, Dow Jones Industrial Average, and the S&P
500.
The Dow Jones
• The DJIA (Dow Jones Industrial Average) is
the oldest and most recognized American
index.
• It is an index that consists of large cap, blue
chip companies.
The Dow Jones Components
Despite the recognition, the index is not a particularly
good representation of the broad market because it
consists of only 30 companies.
Wal Mart
McDonalds
Microsoft
Exxon
International Paper
Hewlett Packard
United Technologies
Caterpillar
American Express
Alcoa
DuPont
General Electric
Citigroup
AT+T
Coca Cola
General Motors
IBM
Honeywell
Home Depot
JP Morgan
3M
Johnson & Johnson
Merck
SBC Comm.
Phillip Morris
Boeing
Proctor & Gamble
Dow Jones Performance
Ending 12/31/01
Time
Average Annual
3 Years
2.8%
10 years
20 Years
12.2%
12.9%
Since 1950
7.6%
THE S&P 500
•
S&P stands for Standard and Poor’s
•
Most of the stocks in this index would be
considered large cap growth stocks.
•
The average capitalization is 8 billion
•
Typically, all the stocks in the Dow are also in
the S&P 500
THE S&P 500
• The S&P 500 is a broader index than the
DJIA because it comprises 500 stocks in 13
different industries.
• Because it is broader than the DJIA, it is
probably a better performance gauge of
companies in the large cap arena.
S&P 500 Contents
There are 13 industries represented in the S&P 500, with
various weightings that change according to performance.
Sector
Weight
Sector
Weight
Basic Materials
4%
Healthcare
15%
Consumer Cyclical
9%
Telecommunications
4%
Consumer Non-Cyclical
9%
Technology
16%
Energy
7%
Commercial Services
5%
Industrials
3%
Financials
20%
Utilities
2%
Consumer Services
5%
Transportation
1%
S&P 500 Performance
Ending 12/31/01
Time
Average Annual
3 Years
-3.5%
10 years
10.6%
20 Years
11.8%
Life (1950)
8.2%
Russell 2000
• The Russell 2000 consists of 2000 stocks and
measures the performance in the small cap
segment of the stock market.
• Average capitalization is around 1 billion.
Russell 2000 Performance
Ending 12/31/01
Time
Average Annual
3 Years
5.1%
10 years
9.89%
Life (1987)
10.53%
S&P 400
• Measures 400 stocks that are meant to
represent the mid-cap stocks in the market
• Average capitalization is about 2-4 billion
S&P 400 Performance
Ending 12/31/01
Time
Average Annual
3 Years
12.1%
5 years
17.28%
Life (1992)
12.78%
NASDAQ Composite
• The NASDAQ represents primarily the technology
segment of the market, but also contains retail and
financial companies.
• There are approximately 3500 stocks that are represented
in this index
• The capitalization's of these stocks can vary widely
NASDAQ Contents
The NASDAQ primarily consists of 5 technology
sub-segments:
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•
•
Telecommunications
Semiconductors
Software
Networking
Biotechnology
NASDAQ 100
• The NASDAQ 100 is the 100 largest capitalization
companies from within the NASDAQ Composite
• It is re-weighted every January
NASDAQ Performance
Ending 12/31/01
Time
Average Annual
3 Years
-3.8%
10 years
12.8%
Life (1984)
12.41
Wilshire 5000
• Measure of 5000 companies in a wide variety of
industries, with a wide variety of capitalizations
• Because of this breadth, it is considered on of the
best indicators of the overall health of the
American stock market
Wilshire 5000 Performance
Ending 12/31/01
Time
Average Annual
3 Years
-1.8%
5 years
8.26%
Life (1990)
11.92%
Capitalization Effects
• All major indexes, with the exception of the DJIA, are
capitalization-weighted.
• The effect of this is that larger companies within the
index tend to dictate the movement of the index.
Example: Capitalization
Let’s create a very simplistic example of a capitalization weighted
index comprising of 5 stocks: A,B,C,D,E. All have the same
share price of $10.
A
B
C
D
E
Shares
Outstanding
100
10
10
10
10
Share Price
$10
$10
$10
$10
$10
Capitalization
1000
100
100
100
100
Example: Capitalization
Company A is a much larger capitalized company with 10 times the
number of shares outstanding than B,C,D, and E.
A
B
C
D
E
Shares
Outstanding
100
10
10
10
10
Share Price
$10
$10
$10
$10
$10
Capitalization
1000
100
100
100
100
Thus, since they all have the same share price, company
A’s capitalization is 10 times as large as the others, and
will have 10 times the impact on the index.
Example: Capitalization
A
B
C
D
E
Shares Outstanding
100
10
10
10
10
Share Price
$10
$10
$10
$10
$10
Capitalization
1000
100
100
100
100
The total value of this index would be the sum of all the
capitalization’s (shares x price), which is…
1000 + 100 + 100 + 100 + 100 =
1400
Example: Capitalization
Now let’s say the price of Company A decreased by $1, and
the prices of B,C,D, and E all increased by $1.
A
B
C
D
E
Shares
Outstanding
100
10
10
10
10
Share Price
$9
$11
$11
$11
$11
Capitalization
900
110
110
110
110
The NEW value of this index would be the sum of all the
capitalization’s, which is…
900 + 110 + 110 + 110 + 110 =
1340
-60 change
What Happened?
4 of the 5 stocks in our index went up, yet the
index fell in value!!
How?
Capitalization! It doesn’t matter how many stock went
up or down, the indexes measure the overall change in
total capitalization.
What This Means
It means simply that larger stocks will have
more impact on the direction of the index
than do the smaller stocks in the index.
More Terminology
Often times indexes will move up for extended periods,
even though more stocks are declining than are
gaining…
this is known as a thin, or narrow market.
Removing Capitalization Effect
• The DJIA is the only major index that is controlled by the
share price rather than the capitalization. (But since only 30
companies make up the index, one or two stocks can have a very large
impact on the value).
• The Wilshire 4500 and the Value Line Geometric indices
also mitigate the effect of capitalization
Wilshire 4500
• The Wilshire 4500 removes the dominating
capitalizations from the Wilshire 5000.
• The 500 stocks that comprise the S&P 500, which have
very large capitalizations, are removed from the 5000,
which leaves 4500.
Value Line Geometric Index
•
Comprised of 1500 stocks of varying capitalization from
various market segments
•
Treats each stock as 1. Thus, if more stocks go up than
down, regardless of capitalization, then the index will go up.
•
Is often used to determine the breadth, or overall
participation of stocks, during market advances or declines.
Changing The Indexes
All indexes will change their composition from
time to time, but generally the stocks within
the index remain fairly static.
Why change a company at all?
–
–
–
–
Changes in capitalization
No longer representative of the industry
Mergers
Bankruptcies
Using The Indexes
• Indexes should be used as a barometer to measure the
performance of mutual funds.
• An index is normally quite static, in that the 500
stocks in the S&P 500 don’t change very often.
• If your mutual fund, which is professionally
managed, cannot outperform a static index, you
should ask yourself what you are paying for.
Comparing Apples
• When comparing fund to an index, be sure you use the
right comparisons
• A small cap growth fund would be compared to the
Russell 2000, not the S&P 500.
About Index Funds
What is it?
– An index fund simply buys all the exact same stocks that
are in the underlying index.
– An S&P 500 index fund would simply own all 500 stocks
that are in the S&P 500 index.
– An index fund is simply a clone of the index which
investors can buy very easily.
Why Use Index Funds
– An index fund has very low internal expenses.
Since the portfolio is rarely changed, transaction
costs are very low and there is no need to hire a
professional advisor.
– With these lower expenses, index funds often have
a 1% head start over actively managed funds.