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Indexing the Indexes

Stock Market News

March 2001

Indexing the Indexes

Everywhere you go these days, it seems you can't get away from indexes. If it's not the Dow Jones Industrials Average, you have to contend with the NASDAQ Composite. If your lucky enough to avoid these two indexes, someone is talking about the S&P 500 or the Russell 1000.

Did you ever stop and wonder what the big deal is with these indexes and why everyone keeps talking about them? Oh sure, you know they all deal with the stock market and investing, but what makes them so special? What makes one different from another?

That's what we will be talking about this month. The birth and life of some of our more popular stock and bond market indexes.

Is there really a guy named Dow Jones?

Believe it or not, there is no one named Dow Jones. However, Charles Dow was a reporter in the 19th century who teamed up with another reporter, Edward D. Jones (unrelated to the brokerage house of the same name) to create Dow Jones & Company in 1882. The business then, as now, was dedicated to reporting financial news to the investing community - financial institutions in those days.

In 1883, Dow Jones & Company began printing a sheet detailing the daily news. This "news sheet" later became "The Wall Street Journal."

In 1884, Dow began publishing his averages as a means of reporting on the movements of the overall stock market. By 1896, Dow had created two indexes. The Dow Jones Railroad Average consisted of 20 railroad stocks and the Dow Jones Industrial Average, which originally consisted of 12 non-railroad stocks. Today the Dow Jones Industrial Average consists of 30 non-railroad stocks while the Railroad Average, now the Dow Jones Transports Index consists of 20 transportation companies. The Dow Jones Utilities Index includes 15 stocks.

Unlike other averages, the Dow Jones indexes are not weighted average indexes. Therefore, a price movement in one Dow stock will have the same effect as the price movement of another stock, regardless of the overall market capitalization of the particular company's stock.

Why would I care about Poor Standards?

Forgive the play on words, but we couldn't resist. Another very widely reported index is the S&P 500.

The chief criticisms of the Dow Jones Averages were, and still are, that the stocks chosen are not broad enough to cover all of the market variations, nor is it appropriate to give equal weighting to a small company and a large company in determining their effect on the market.

In order to provide a “more representative” index, Standard & Poor’s introduced the S&P 500 in 1957. Although it’s origins go back to 1923, when S&P calculated a series of indices based on 233 stocks in 26 separate categories, the S&P 500 consolidated these indices into one overall index which now encompasses approximately 90 specific industry groups.

The S&P 500 includes four major industry groups: Industrials, Utilities, Financials and Transportation. However, the number of stocks in these groups varies based on current market conditions. The S&P 100, a subset of the S&P 500 represent the 100 largest companies in the S&P 500 index.

Contrary to the Dow, due to the weighting mechanism in the S&P 500 index, a large price move in one specific stock will not translate into a major movement of the overall index. Accordingly, proponents of the S&P 500 believe this is the more accurate indicator of the overall market.

In addition to the S&P 500, S&P has published the S&P MidCap 400 Index since 1991. This includes 400 stocks with a market capitalization (shares outstanding times stock price) ranging from $300 million to $5.2 billion.

What about the Nasdaq?

While the S&P and Dow Jones indices include stocks traded at many different exchanges, only the Nasdaq Composite Index remains true to one exchange – the Nasdaq Stock Market. This index is, like the S&P 500, a market-value weighted index. However, unlike the S&P 500, this index includes all stocks listed on the Nasdaq Stock Market. At last count, this represented approximately 5,000 companies.

While the advantages of using this index as an indicator of the markets are obvious, the main downfall of the Nasdaq Composite index is that it doesn’t cover all of the markets. Leaving the New York and American Exchanges out of the mix doesn’t give the full story for the stock markets as a whole. Still, the index is broad enough and enough investors have a stake in the Nasdaq stocks that this is one of the three most quoted indices in gauging overall stock market performance.

Who’s this guy Russell and how come so many people like his indices?

The Frank Russell Company produces 21 indices covering the U. S. equity markets. Probably the best known indices are the Russell 1000, 2000 and 3000 and Small Cap Completeness indices.

The Russell 3000 comprises the 3,000 largest U. S. companies based on market capitalization. Together, these companies represent about 98% of the “investible” U. S. equity market. The market capitalization of companies in this index ranges from $178 million to $520 Billion.

The Russell 2000 includes the 2,000 smallest companies in the Russell 3000 Index. Together, these companies comprise approximately 8% of the total market capitalization of the Russell 3000 Index. The capitalization of companies in this index ranges from $178 million to $1.5 billion.

The Russell 1000 includes the 1,000 largest companies in the Russell 3000 Index. Representing 92% of the market capitalization of the Russell 3000 index, these companies have a market capitalization ranging from $1.5 billion to $520 billion.

The Russell Small Cap Completeness Index measures the performance of the Russell 3000 companies that are not included in the S&P 500 Index. The capitalization of the companies included in this index ranges from $178 million to $69 billion.

Is this index named after the Boulevard, or not?

Whether the Wilshire Total Market Index is named after the famed Wilshire Boulevard in California or not, we don’t know. It really doesn’t make any difference either. What does make a difference is that this index measures the performance of all companies headquartered in the U. S. and for which there are ready market quotations.

At last count, the index is comprised of over 7,000 capitalization weighted stocks and is a very good indicator of the approximated dollar change in U. S. stocks.

You know, this is really interesting stuff, but who cares?

The indices described in the preceding paragraphs are some of the most widely recognized and quoted indices in the stock market universe. They are not the only ones.

Regardless of which indices you follow, you should care what the general trend of those indices is. By knowing the trends of the indices and the companies included in the indices, you will gain a better understanding of where the market is in general.

Nowhere is this more easily understood than in looking at the Nasdaq Composite. Technology stocks very heavily weight this index. A general trend downward in this index may mean the technology stocks are out of favor. Thus, you may want to stay out of the technology sector during a downward trend in the Nasdaq. On the other hand, this may mean you want to buy if you are a “bargain hunter.” We will leave that choice to you.

This same analysis is true of all the major indices.

Which is the best index to follow? That depends on what interests you. Ultimately, your ability to make the right investment choices depends on your understanding of all the major indices and their reaction to varying economic environments. This, along with a well defined financial plan and investment philosophy will help you maximize your investment earnings and minimize losses in those inevitable downturns.

If you would like to know more about any of these indexes, you can go to the following links:

Dow Jones & Company

Standard & Poor’s, Inc.

The Nasdaq Stock Market

Frank Russell Company

Wilshire Associates

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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