Chapter 5. Say Cheese: Getting a Snapshot of the Market with Indexes

In This Chapter

  • Defining index basics

  • Looking at the Dow and other indexes

  • Exploring indexes for practical use

"How's the market doing today?" is the most common question that interested parties ask about the stock market. "What did the Dow do?" "How about Nasdaq?" Invariably, people asking those questions expect an answer regarding how well the market performed that day. "Well, the Dow fell 157 points to 12,500, while Nasdaq was unchanged at 2,449." The Dow and Nasdaq are indexes, which are statistical measures that represent the value of a batch of stocks. You can use indexes as general gauges of stock market activity. From them, you get a basic idea of how well (or how poorly) the overall market (or a portion of it) is doing. In this chapter, I focus my attention on the major stock market indexes and how to use them.

Knowing How Indexes Are Measured

Note

The oldest stock market index is the Dow Jones Industrial Average (DJIA or simply "The Dow"), which was created by Charles Dow (of Dow Jones fame) in 1896. The Dow covered only 12 stocks then, but the number increased to 30 stocks in 1928, and it remains the same to this day. Because Dow worked long before the age of computers, he kept the calculations of his stock market index simple and did them arithmetically by hand. Dow added up the stock prices of the 12 companies and then divided the sum by 12. Technically, this number is an average and not an index (hence the word "average" in the name). For simplicity's sake, I refer to it as an index. Besides, the number gets tweaked nowadays to account for things such as stock splits. (For more on stock splits, see Chapter 20).

Note

However, indexes and averages get calculated differently. The primary difference is the concept of weighting. Weighting refers to the relative importance of the items when they're computed within the index. Several kinds of indexes exist, including:

  • Price-weighted index: This index tracks changes based on the change in the individual stock's price per share. For example, suppose you own two stocks: Stock A, worth $20 per share, and Stock B, worth $40 per share. A price-weighted index allocates a greater proportion of the index to the stock at $40 than to the one at $20. If the index contained only these two stocks, the index number would reflect the $40 stock as being 67 percent (two-thirds of the total), while the $20 stock would be 33 percent (one-third of the total). The Dow is a good example of a price-weighted index.

  • Market-value weighted index: This index, also known as a capitalization-weighted index, tracks the proportion of a stock based on its market capitalization (or market value, also called market cap).

    Say that in your portfolio, you have 10 million shares of a $20 stock (Stock A) and 1 million shares of a $40 stock (Stock B). Stock A's market cap is $200 million, while Stock B's market cap is $40 million. Therefore, in a market-value weighted index, Stock A represents 83 percent of the index's value because of its much larger market cap. An example of a market-value weighted index is the Nasdaq Composite Index.

  • Broad-based index: The sample portfolios in the preceding bullets show only two stocks — obviously not a good representative index. Most investing professionals (especially money managers and mutual fund firms) use a broad-based index as a benchmark to compare their progress. A broad-based index provides a snapshot of the entire market. The S&P 500 and the Wilshire 5000 are good examples of broad-based indexes (they also happen to be market-value weighted indexes; see descriptions of both indexes later in this chapter.)

  • Composite index: This index is a combination of several averages or indexes. An example is the New York Stock Exchange (NYSE) Composite, which tracks all the stocks on the NYSE. Another example is the Nasdaq Composite Index, which is a market-capitalization composite index of 3,000 companies on Nasdaq. (I discuss Nasdaq later in this chapter.)

  • Performance-based index: This index includes not only the appreciation of the stocks represented in the index but also the dividends (and other cash payouts) issued to stockholders. The DAX (the most widely followed German index, composed of 30 major German companies) is a performance-based index.

Checking Out the Indexes

Although most people consider the Dow, Nasdaq, and Standard & Poor's 500 to be the stars of the financial press, you may find other indexes equally important to follow because they cover other significant facets of the market, such as small cap and mid cap stocks, or specific sectors and industries.

Tip

For example, if you invest in an Internet stock, you should check the Internet Stock Index to compare how your stock is doing when measured against the index. You can find indexes that cover industries such as transportation, brokerage firms, retailers, computer companies, and real estate firms. For a comprehensive list of indexes, go to www.djindexes.com (a Dow Jones & Co. Web site). The most reliable and most widely respected indexes are produced not only by Dow Jones but also Standard & Poor's and the major exchanges/markets themselves, such as the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and Nasdaq. Smaller exchanges also issue or provide indexes (such as the Philadelphia Exchange). Web sites for different exchanges can be found in Appendix A.

The Dow Jones Industrial Average

The most famous stock market barometer is my first example in the previous section — the Dow Jones Industrial Average (DJIA). When someone asks how the market is doing, most investors quote the DJIA (simply referred to as "the Dow"). The Dow is price weighted and tracks a basket of 30 of the largest and most influential public companies in the stock market. I list the stocks tracked on the Dow and discuss the Dow's drawbacks in the following sections.

The companies of the Dow

The following list shows the current roster of 30 stocks tracked on the DJIA (in alphabetical order by company, with their stock symbols in parentheses).

Alcoa (AA)

American Express Co. (AXP)

AT&T (T)

Bank of America (BAC)

Boeing (BA)

Caterpillar (CAT)

Chevron (CVX)

Citigroup (C)

Coca-Cola Co. (KO)

Disney & Co (DIS)

DuPont (DD)

Exxon Mobil (XOM)

General Electric (GE)

General Motors (GM)

Hewlett-Packard (HPQ)

Home Depot (HD)

Intel (INTC)

International Business Machines (IBM)

Johnson & Johnson (JNJ)

J.P. Morgan Chase (JPM)

Kraft Food Inc. (KFT)

McDonald's (MCD)

Merck (MRK)

Microsoft (MSFT)

Minnesota Mining and Manufacturing (also known as 3M) (MMM)

Pfizer (PFE)

Procter & Gamble (PG)

United Technologies (UTX)

Verizon (VZ)

Wal-Mart Stores (WMT)

The drawbacks of the Dow

Note

The Dow has survived as a popular gauge of stock market activity for over a century because it was the first such statistical snapshot of the stock market, which helped it become quickly entrenched as a widely followed and quoted barometer. Although it's an important indicator of the market's progress, the Dow does have one major drawback: It tracks only 30 companies. Regardless of their status in the market, the companies in the Dow represent a limited sampling, so they don't communicate the true pulse of the market. For example, when the Dow surpassed the record 10,000 and 11,000 milestones during 1999 and 2000, the majority of (nonindex) companies showed lackluster or declining stock price movement. (See the "Dow Jones milestones" sidebar, later in this chapter, for more information.)

Note

The roster of the Dow has changed many times during the 100-plus years of its existence. The only original company from 1896 is General Electric. Dow Jones made most of the changes because of company mergers and bankruptcy. However, Dow Jones also made some changes simply to reflect the changing times. In September 2008, as AIG Corp.'s stock was plummeting because of the credit crisis on Wall Street, it was quickly removed from the Dow and replaced with Kraft Foods. At that time, AIG fell from $25 per share to $3 per share within days. Had AIG stayed in the Dow, the Dow would have shown a larger drop, but it maintained a higher level because of the quick replacement. Investors unaware of such moves can be fooled regarding the market's health — another drawback of the Dow.

The Dow isn't a pure gauge of industrial activity because it also includes a hodgepodge of nonindustrial companies such as J.P. Morgan Chase and Citigroup (banks), Home Depot (retailing), and Microsoft (software). During this decade, true industrial sectors like manufacturing had difficult times, yet the Dow rose to record levels.

Given the Dow's shortcomings, serious investors also look at the following indexes:

  • Broad-based indexes: The S&P 500 and the Wilshire 5000 are more realistic gauges of the stock market's performance than the Dow. (I discuss these indexes later in this chapter.)

  • Industry or sector indexes: These indexes are better gauges of the growth (or lack of growth) of specific industries and sectors. If you buy a gold stock, for example, you should track the index for the precious metals industry.

Tip

Dow Jones has several averages, including the Dow Jones Transportation Average (DJTA) and the Dow Jones Utilities Average (DJUA). Dow Jones manages both of these indexes more strictly than the Dow, so they tend to be a more accurate barometer of the market they represent. Find out more about the Dow Jones indexes at www.djindexes.com.

Standard & Poor's 500

The Standard & Poor's 500 (S&P 500) tracks 500 leading publicly traded companies considered to be widely held. The publishing firm Standard & Poor's created this index (I bet you could've guessed that). Because it contains 500 companies, the S&P 500 more accurately represents overall market performance than the DJIA, with its 30 companies. Money managers and financial advisors actually watch the S&P 500 stock index more closely than the Dow. Most mutual funds especially like to measure their performance against the S&P 500 rather than any other index, although mutual funds that concentrate on small cap stocks usually prefer an index that has more small cap stocks in it, such as the Russell 2000 (which I discuss later in this chapter).

The S&P 500 doesn't attempt to cover the 500 biggest companies. Instead, it includes companies that are widely held and widely followed. The companies are also industry leaders in a variety of industries, including energy, technology, healthcare, and finance.

Note

Although it's a reliable indicator of the market's overall status, the S&P 500 also has some limitations. Despite the fact that it tracks 500 companies, the top 50 companies make up 50 percent of the index's market value. This situation can be a drawback, because those 50 companies have a greater influence on the index's price movement than any other segment of companies. In other words, 10 percent of the companies have an equal impact to 90 percent of the companies on the same index. Therefore, although the index better represents the market than the DIJA, it doesn't give a perfectly accurate representation of the general market.

Standard & Poor's doesn't set the 500 companies it tracks in stone — S&P can add or remove companies when market conditions change, removing a company if it isn't doing well or goes bankrupt, for instance, and replacing it with a company that's doing better. You can find out more at www.standardandpoors.com.

Wilshire Total Market Index

The Wilshire 5000 Equity Index, often referred to as the Wilshire Total Market Index, is probably the largest stock index in the world. Wilshire Associates started out in 1980 tracking 5,000 stocks. Since then, the Wilshire 5000 has ballooned to cover more than 7,500 stocks. The advantage of the Wilshire 5000 is that it's very comprehensive, covering nearly the entire market (at the very least, the Wilshire 5000 tracks the largest publicly traded stocks). It includes all the stocks on the major stock exchanges (NYSE, AMEX, and the largest issues on Nasdaq), which by default also includes all the stocks covered by the S&P 500. Investors and analysts who seek the greatest representation/performance of the general market look to the Wilshire 5000.

The Wilshire 5000 is a market-value weighted index that also performs as a broad-based index. The Wilshire indexes are maintained by Wilshire Associates Incorporated, and you can find out more at www.wilshire.com.

Nasdaq indexes

Nasdaq became a formalized market in 1971. The name used to stand for "National Association of Securities Dealers Automated Quote" system, but now it's simply "Nasdaq" (as if it's a name like Ralph or Eddie). Nasdaq indexes are similar to other indexes in style and structure. The only difference is that, well, they cover companies traded on the Nasdaq (www.nasdaq.com). The Nasdaq has two indexes, both of which are reported in the financial pages:

  • Nasdaq Composite Index: Most frequently quoted on the news, the Nasdaq Composite Index covers about 3,000 companies that trade on Nasdaq. The companies encompass a variety of industries, but the index's concentration is primarily technology, telecommunications, and related sectors. The Nasdaq Composite Index hit an all-time high of 5,048 in March 2000 before the worst bear market in its history occurred. The index dropped a whopping 77 percent by 2002 to bottom out at 1,114 in October 2002. As of early October 2008, the Nasdaq was at approximately 1,740 (still way below its all-time high, but higher than its bottom six years earlier).

  • Nasdaq 100 Index: The Nasdaq 100 tracks the 100 largest companies in Nasdaq based on size in terms of market capitalization. This index is for investors who want to concentrate on the largest companies, which tend to be especially weighted in technology. It provides extra representation of technology-related companies such as Microsoft, Adobe, and Symantec.

Note

Although these indexes track growth-oriented companies, the stocks of these companies are also very volatile and carry commensurate risk. The indexes themselves bear this risk out; in the bear market of 2000 and 2001 (and even extending into 2002), they fell more than 60 percent. You can find out more about Nasdaq's indexes at www.nasdaq.com.

Russell 3000 Index

The Russell 3000 Index is a great example of an index that seeks more comprehensive inclusion of U.S. companies. It's a performance-based index that includes the 3,000 largest publicly traded companies (nearly 98 percent of publicly traded stocks). The Russell 3000 is important because it includes many mid cap and small cap stocks. Most companies covered in the Russell 3000 have an average market value of a billion dollars or less.

Russell Investments Group created and maintains the Russell 3000 Index, as well as the Russell 1000 and the Russell 2000. The Russell 2000 contains the smallest 2,000 companies from the Russell 3000, while the Russell 1000 contains the largest 1,000 companies. The Russell indexes don't cover micro cap stocks (companies with a market capitalization under $250 million). You can find out more at www.russell.com.

International indexes

Investors need to remember that the whole world is a vast marketplace that interacts with and exerts tremendous influence on individual national economies and markets. Whether you have one stock or one mutual fund, keep tabs on how world markets affect your portfolio. The best way to get a snapshot of international markets is, of course, with indexes. Here are some of the more widely followed international indexes:

  • BSE SENSEX (India): The most widely followed index of Indian stocks is also referred to as the "BSE 30 Index" and is a value-weighted index maintained by the Bombay Stock Exchange (www.bseindia.com).

  • CAC-40 (France): This market-capitalization weighted index tracks 40 of the largest public stocks that trade on Paris's stock exchange, the Euronext Paris.

  • DAX (Germany): This index is similar to our DJIA in that it tracks 30 blue chip stocks (the largest and most active that trade on the Frankfurt Exchange).

  • FTSE-100 (Great Britain): Usually referred to as the "footsie," this market-value weighted index includes the top 100 public companies in the United Kingdom.

  • Halter USX China Index (China): This index tracks a basket of 50 market-value weighted U.S. public companies that derive most of their revenues from China.

  • Hang Seng Index (Hong Kong): This market-value weighted index tracks the top 45 companies on the Hong Kong Stock Exchange.

  • Nikkei (Japan): This index is considered Japan's version of the Dow. If you're invested in Japanese stocks or in stocks that do business with Japan, you want to know what's up with the Nikkei.

  • SSE Composite Index (Shanghai): This is an index of all the stocks that trade on the Shanghai Stock Exchange.

Tip

You can track these international indexes (among others) at major financial Web sites such as www.bloomberg.com and www.marketwatch.com. You may find international indexes useful in your analysis as you watch your stocks' progress. What if you have stock in a company that has most of its customers in Japan? Then the Nikkei can help you get a general snapshot of how well the major companies are doing in Japan, which in turn can be a general barometer of Japan's economic health. If your company's business partners or customers are in the Nikkei and it's plunging, you know it's probably "sayonara" for the company's stock price.

As for me, I'm still waiting for the "Galaxy 1 Million Index" — no point in being overweight with Earth stocks, you know.

Using the Indexes Effectively

You may be wondering which indexes you should be checking out and exactly what you should do with them. The sections that follow give you some idea of how to put all the pieces together.

Tracking the indexes

Note

The bottom line is that indexes give investors an instant snapshot of how well the market is doing. Indexes offer a quick way to compare the performance of one investor's portfolio with the rest of the market. If the Dow goes up 10 percent in a year and your portfolio shows a cumulative gain of 12 percent, then you know you're doing well. Appendix A lists resources to help you keep up with various indexes.

Warning

The problem with indexes is that they can be misleading if you take them too literally as an accurate barometer of stock success. For example, the Dow has changed its roster of companies many times since 1896. Had it not, the Dow's general upward trajectory in the past few decades would have been much different. Laggard stocks have been dropped and replaced with stocks that have shown more promise. Many of the original companies that were in the DJIA in 1896 went out of business or were bought by other companies that aren't reflected in the index.

Investing in indexes

If the market is doing well but your specific stock isn't, can you find a way to invest in the index itself? Yes, and with investments based on indexes, you can invest in the general market or a particular industry.

Tip

Say you want to invest in the DJIA. After all, why try to beat the market if just matching it is sufficient to grow your wealth? Why not have a portfolio that directly mirrors the DJIA? Well, it's too impractical and expensive to invest in all 30 stocks in the DJIA. Fortunately, alternatives can accomplish the act of investing in indexes. Here are the best ways:

  • Index mutual funds: An index mutual fund is much like a regular mutual fund except that it only invests in securities (in this case, stocks) that match as closely as possible the basket of stocks in that particular index. For example, you can find index mutual funds that track the DJIA and the S&P 500. Find out more about index mutual funds at places such as Morningstar (www.morningstar.com).

  • Exchange-traded funds (ETFs): This is a particular favorite of mine. ETFs have similar characteristics to mutual funds except for a few key differences. An ETF can reflect a basket of stocks that mirror a particular index, but you can trade the ETF like a stock itself. You can transact ETFs like stocks in that you can buy, sell, or go short. You can put stop losses on them, and you can even purchase them on margin (see Chapter 18 for more on stop losses and buying on margin). ETFs can give you the diversification of mutual funds coupled with the versatility of stocks. Examples of ETFs that track indexes are the DJIA ETF (symbol DIA) and the ETF for Nasdaq (QQQ). You can find out more about ETFs at the American Stock Exchange (www.amex.com).

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