Tuesday, June 26, 2018

What Is A Stock Market Index, And Why Do Investors Watch Stock Indices?
June 25, 2018, 10:22:46 AM EDT
By Martin Tillier

The nature of my job means that I follow the stock market closely, but it also means that I tend to do so through individual stocks rather than indices (if you're wondering, by the way, about the usage of "indices" versus "indexes," check out this article). That is why, when I read on Friday that the Dow was trying to avoid its longest losing streak in forty years, I was taken aback.

From the perspective of the individual stocks I follow, it just didn’t seem that bad. In part that is because I write here, and therefore tilt towards an interest in Nasdaq-listed stocks.

During the Dow’s potentially historic slide the Nasdaq had climbed around 1.5% before dropping back to finish the nine-day period essentially flat.

To a lot of casual observers and newcomers to the market, that is probably confusing. How can stocks be going up and down at the same time? To understand why that can happen you have to understand the nature of indices. First, there is no one, universal measure of “the stock market.”

There are around four thousand actively traded stocks on the NYSE and Nasdaq combined, and around another fifteen thousand listed companies whose stock is not traded frequently.

These days, tracking all of them would be relatively easy, but pointless and misleading. The majority of those nineteen thousand or so stocks are thinly traded, resulting in big moves in price that are unrelated to the state of the economy, or much else of use to the observer.

Still, rather than look at individual holdings, most investors would rather see an average number to which they can easily relate as an indicator of market strength. That is where the indices come in.

Back in 1896, the financial reporters Charles Dow and Edward Jones were looking for a way to give their readers that indicator of strength and began to publish an average of the biggest stocks in each of the twelve different sectors of the market at the time. What is now the Dow Jones Industrial Average was born, but even then, its main flaw was apparent.

It encompassed only the biggest stock in each sector and, while their performance was important, it was not necessarily indicative of economic conditions or the overall performance of listed companies. Capitalism is based on competition so relative strength in each sector is constantly changing. “Biggest” in a sector doesn’t always mean “best.” Overall growth can easily be absorbed by a growing company that is not yet the biggest, making an index based on size unrepresentative of the overall market.

Still, that didn’t hurt the Dow too much. It became, and has remained, the main way the market is followed by individual investors. It has grown over time and now includes thirty stocks but remains representative of only an elite group of mega-companies. In an attempt to offer a more representative sample, the analysis company Standard & Poor began publishing its own index in 1923. At first that too included only a small number of stocks, but was expanded to ninety companies three years later, then to its current 500 components in 1957.

The third major index, the Nasdaq, is a lot younger. The Nasdaq exchange was founded by the National Association of Securities Dealers in 1971 as an electronic alternative to the open outcry system still being used by the NYSE. The new exchange attracted younger, more dynamic tech companies that were growing rapidly rather than the more mature, staid Dow components, so when the exchange formed an index of its listed companies, it was representative of those types of businesses.

Basically, the Dow represents big, traditional companies, while the Nasdaq is more tilted towards areas of growth such as tech. The S&P 500 now encompasses some of both and is therefore usually used by economists and analysts as the best measure of overall market performance, but I would make an argument for the Nasdaq being the more reliable indicator, and not just because they publish my thoughts and ramblings.

The days of “What’s good for General Motors is good for America” are long gone, no matter how reluctant some, including the current President, are to deal with that reality. The U.S. no longer leads the world in manufacturing, but it is dominant in tech and innovation. If that is where the strength and growth is, the Nasdaq is a far better indicator of that strength and growth than the Dow, or even the broader S&P.

So, next time you hear tales of a big decline in the Dow, stop and check the other indices before you hit the “sell all” button. If you understand the nature of the different indices it is clear that what we have seen over the last couple of weeks as the Dow has fallen is not about broad economic weakness.

The Nasdaq’s concurrent rise tells us that rather it is about a shift of capital from the relatively safe industrials to the riskier tech sector. Given that Trump’s escalating trade war with the entire world is at least partly to blame for the Dow’s collapse it is hard to see that as the positive signal it could be, but still, what is essentially a rotation to another sector is hardly a reason to panic.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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