There are hundreds of different stock market indices in the US, so it is not surprising that investo...
There are hundreds of different stock market indices in the US, so it is not surprising that investors often find it difficult to distinguish which index gives the best representation of the US stock market. For readers of the business pages in the UK's mainstream media, the Dow Jones Industrials and the Nasdaq are often the only indices quoted.
It may appear surprising, then, that most US portfolio managers will look at the performance of the S&P500 index as an indication of how the US stock market has performed. In order to illustrate the differences between the indices and to appreciate why the S&P500 index is the most frequently used measure, it is necessary to look at the history, the method of calculation and the breakdown of the constituent companies within each index.
The reason why the Dow Jones Industrial Average (DJI) is probably the most widely quoted index in the world rests solely on the fact that it is the oldest stock market measure. The index was first calculated by Charles Henry Dow on 26 May 1896, using only 12 stocks, and the price has been quoted daily ever since.
The DJI today contains 30 companies and has done since 1928. The editors of the Wall Street Journal are responsible for selecting the constituent stocks and reviewing them for suitability. Changes are infrequent and normally occur when companies decide to acquire or merge. When Chase Manhattan acquired JP Morgan, for example, the new JP Morgan Chase took the place of the old JP Morgan. If the GE acquisition of Honeywell is approved, this will create a slot for another company to be added to the index, since both companies are currently members of the DJI.
There is no published criteria for inclusion in the index. To be included, however, a company appears to have to be a leader in their respective business, have a history of successful growth, and have stock widely held by institutional and individual investors.
Because there are separate Dow Jones indices for utilities and transportation stocks, companies that are in these businesses cannot be selected.
The index is often criticised because 30 stocks are not enough to represent the US economy. There is simply not the scope to cover all the different industries in the US economy with only 30 companies. As evidence, the market value of the stocks in the DJI is only around 25% of the market value of all listed US stocks.
Because additions and deletions to the index are uncommon, important companies in key industries can be left out. Microsoft and Intel were only added to the DJI in November 1999. Cisco Systems is the second largest company by market capitalisation in the US and has had a significant impact on the US economy in the last five years, yet it is not in the DJI.
Another important aspect of the DJI is its method of calculation. The index is still calculated the same way it was in 1896 - price-weighted.
In crude terms, the value of the index is simply all the constituent companies' stock prices added together and averaged (in reality, the divisor has evolved to take account of stock splits, new entrants to the index, dividends and so on). The important distinction to with make price-weighting is that if a company has a higher stock price, it has a larger effect on the index.
For example, let's say the stock price of GE rises 10% from $50 to $55 (+$5) and the stock price of 3M also rises 10% from $110 to $121 (+$11). The $11 rise in 3M price will have a bigger impact on the DJI than GE's $5 rise, despite the fact that GE has a market capitalisation of around $440bn, ten times that of 3M. A better method of calculation for an index is capitalisation-weighted.
For these reasons, the DJI has more romantic appeal than tangible use in evaluating the US stock market.
The Nasdaq was the world's first electronic stock market when trading began in 1971. The Nasdaq itself is not an index, it is a marketplace, like the New York Stock Exchange (NYSE), founded in order to trade over-the-counter securities. In 1994, trading volume on the Nasdaq actually surpassed that of the NYSE and has continued to accelerate since then.
There are several indices that track Nasdaq-traded stocks, the most common of which are the Nasdaq Composite and the Nasdaq 100. When commentators refer to the performance of the 'Nasdaq', they are referring to the performance of the Nasdaq Composite index.
In direct contrast to the DJI, all Nasdaq indices are capitalisation-weighted.
With capitalisation-weighting, a weighting is assigned to each stock in the index, in proportion to its market capitalisation. Hence, in the example given for the price-weighted index, GE would have a weighting ten times that of 3M, therefore any GE stock price movement would have ten times the impact on the index. That is to say, the 3M stock would need to rise 10% to have the same effect on the index as GE's stock moving 1%.
If people argue that an index should represent the US economy, it makes sense that GE has a bigger impact on the index than 3M - with over $110bn in sales and around 340,000 employees, GE has a bigger effect on the US economy than 3M ($15bn in sales and around 70,000 employees).
The Nasdaq Composite contains more than 4,000 stocks, representing virtually all Nasdaq-traded stocks. The Nasdaq 100 is an index of the largest 100 non-financial securities on the Nasdaq. Partly because of its technological leadership, but predominantly because of its less stringent listing requirements, the Nasdaq has become the market of choice for most technology companies looking to float.
Today, more than 80% of the Nasdaq Composite is technology and telecom companies and, therefore, the index can be seen as a proxy to the telecom and technology industry. The index is a useful measure of how well technology stocks are fairing across all US stock markets. Add
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