A stock market is a place where buyers and sellers trade the shares of specific companies. But what is a Stock Market Index? Some investors, and much of the non-investing public, tend to think of a stock market as having some common definition—after all, the financial news of the day is littered with colorful phrases like, “Stock Market Crushed,” or “Stock Market on Fire,” or “Stock Market at Record Lows.”

In reality, a stock market is a collective of the stocks of companies—companies that vary a great deal by size, by share price, and by business model. A stock market index slices out a portion of the entire market based on different criteria. Segmenting a market into indices allows analysts and investors to gauge the performance of the segment in different ways. There are major stock indices that group stocks globally, nationally, and regionally. In theory, a major index can be used as a gauge of the overall economic condition of the segment that it represents. In practice, when investors and others talk about the stock market going up or down, they are actually referring to the performance of one or more major stock market indices.

A Global Market Index, such as the MSCI World Index, groups large-cap and mid-cap companies from around the world. The most well-known National Stock Market Indices are the U.S. Dow Jones Industrial Average (DJIA) and the Standard & Poor (S&P) 500, the Japanese Nikkei, and the U.K. FTSE 100 (Financial Times and London Stock Exchange). There are Regional Indices as well, such as the FTSE Developed Asia Pacific Index, which examine companies in developed economies as opposed to emerging economies.

Finally, there are stock market indices that measure the performance of an industrial classification grouping, such as Biotechnology, Financials, or Utilities.

Again, in theory, the major indices provide general gauges of economic performance globally, nationally, regionally, or within a business segment. Sustained declines in a major national index usually accompany or precede weaker economic conditions. In practice, the way a stock market index is measured exerts a major influence on the predictive value of the index.

A Stock Market Index is used as a way to measure the value of a segment of the total market. Major indices—like the DJIA, the S&P 500, and the FTSE 100—group a sampling of large-cap stocks to allow an approximate gauge of a national economy.

How Stock Market Indices Are Measured

An index like the DJIA has a total value that you often hear in daily financial summaries, such as, “The Dow closed today above 14,500.” That number is a weighted average of the total number of stocks in the index. There are two different values used in the averaging—the share price, and the market capitalization. The Dow is a Price-Weighted Index, although it no longer is a true weighted average. To account for share price variations stemming from stock splits and dividends, the index now uses a calculation method that includes an adjustment measure called the Dow Divisor. The net effect of using share price in order to weight an index is that companies with higher per-share prices have the greatest impact on the index. The table that follows illustrates this point:

Company

Stock Price

Shares Outstanding

Market Cap

Index Weight

Company A

$20

50,000

$1,000,000

20%

Company B

$40

10,000

$400,000

40%

Company C

$40

25,000

$1,000,000

40%

Although Company A and Company C have the same market capitalization, the rise or fall of the share price of Company C will have a greater impact on the index. Company B, at less than half the size of Company C, will exert the same influence on the index as will Company C.

The second method is used for Market-Cap Weighted Indices, like the U.S. S&P 500 and the FTSE 100. With this method, the company’s impact on the index weight is measured by its market cap, not by its share price alone. Share price is obviously part of the equation, but adding shares to put more weight into larger companies with the largest market caps has the greatest impact. The following table again helps to illustrate the point:

Company

Stock Price

Shares Outstanding

Market Cap

Index Weight

Company A

$20

50,000

$1,000,000

41.6%

Company B

$40

10,000

$400,000

16.8%

Company C

$40

25,000

$1,000,000

41.6%

Here you see the difference. The share price of Company A is half that of Company C, but the two companies have equal weight on the index due to identical market caps. In practical terms, weighting by market cap would appear to make an index a better gauge of economic performance, as larger companies theoretically have more of an impact on a national economy even though share price may be lower. In an index that uses price weighting, companies with smaller market caps, and theoretically less of an overall economic impact, can have an outsized effect on the index.

Stock Market Indices use the share price or the market capitalization of index components to calculate the total value of the index. With a Price-Weighted Index, a company with a smaller market cap can have a greater impact on the index value if it has a higher share price; in a Market-Cap Weighted Index the largest companies have the greatest effect.

Using Stock Market Indices as a Gauge of Economic Performance

When the economy is sputtering, the stock market should respond in kind. However, there are those who believe that a falling stock market is like the canary in the coal mind, signaling troubles ahead. Some academic studies conducted in the pre-Internet age of stock trading found that changes in the stock market tended to precede changes in business conditions by an average of about four months, according to a 1975 paper published by the Brookings Institution in the United States.

A well-constructed major index with a sizable sampling of a variety of sizes and types of businesses should, over time, be of assistance to investors who are concerned about stock performance. The key phrases are “well-constructed” and “over time.”

It is puzzling at best that the fabled DJIA still appears to be the darling of financial news outlets. That index is composed of only thirty U.S. Blue-Chip companies. If a Dow component with a lofty share price has a bad quarter for reasons independent of the general economy, it can drag the index down. The S&P 500 is the index that most professional traders and savvy investors follow. As the name implies, it is made up of 500 U.S.-based large-cap companies from all U.S. stock exchanges. Using market cap weighting provides a representation of widely traded stocks. Some claim that the S&P 500 covers approximately 70% of the total U.S. market, leaving others to wonder about the missing 30%.

The value of the index you hear quoted daily is primarily important for technical traders who look for buy and sell points based on a major index breaching a technical level, such as a moving average or support level. What is more important than the pronouncement that the S&P 500 closed at 1850 is the daily percentage increase or decrease. All stock market indices have calculation methods with varying degrees of complexity. Split adjustments and “divisors” used to account for differences in liquidity and daily closing totals are expressed as changes against some theoretical base values.

Despite some limitations, percentage changes in the major indices over time can uncover trends. Think of a stock market index as a snapshot in time. The snapshots taken together serve to uncover the bigger picture.

Although there are some drawbacks in all major indices, tracking the percentage change over a period of time allows investors to see stock market trends, both rising and falling.

Using Stock Market Indices as Starting Points for Stock Trading

Trends seen in major stock-index movements can be an investor’s best friend, regardless of his or her investing strategy. In falling markets, conservative investors may opt to take some profits from successful trades and move to the sidelines. Aggressive investors may look for buying opportunities. Indices are by definition an aggregate, and there are always individual stocks within an index that are going against the trend. Companies with exemplary fundamentals may be dragged down below their intrinsic values.

If the major indices show overall trends, specific sector indices show segments of the business environment that are suffering the most or the least, or reaping the lion’s share of the markets’ largesse. The following table comes from Bloomberg.com, as of 4/22/2014:

Broad Global Market United States Index

Sector

Performance

Price per
Earnings
(TTM)

Price to
Sales (TTM)

Dividend
Yield

1 Month

3 Month

YTD

Consumer Discretionary
17 Industries

-3.44%

-1.76%

-4.48%

16.5x

1.0x

1.27%

Consumer Staples
9 Industries

+2.47%

+3.26%

+1.27%

15.1x

1.0x

2.86%

Energy
3 Industries

+6.44%

+7.20%

+4.94%

14.0x

1.2x

1.74%

Financials
12 Industries

-2.44%

-0.33%

+0.18%

15.2x

2.1x

1.91%

Health Care
8 Industries

-3.86%

-2.65%

+1.72%

18.2x

1.2x

1.86%

Industrials
17 Industries

+1.19%

+0.84%

+0.63%

15.7x

1.1x

1.85%

Information Technology
10 Industries

-2.49%

-0.97%

0.00%

14.8x

2.1x

0.90%

Materials
6 Industries

-0.27%

+2.71%

+2.56%

13.2x

1.1x

1.79%

Telecommunication Services
3 Industries

+2.77%

+3.68%

+0.36%

22.6x

1.3x

4.83%

Utilities
6 Industries

+3.93%

+9.14%

+10.45%

17.1x

1.3x

3.78%

You can think of this table as a treasure map indicating where to begin your hunt for winning stocks. If you like to search for bargain stocks, the Consumer Discretionary Index clearly shows a downward trend for the year to date. If you are a follower of the “Buy High, Sell Higher” school of investing, Utilities and Energy serve as your starting point to search for the “best of breed” within the sector.

offer a buying and selling road map for all types of investors. Investors who like going with a rising tide can look into the stocks in sectors that are outperforming, while bargain-hunting investors can look for “best of breed” stocks in weaker sectors.

Bottom Line

Stock Market Indices come in all sizes and shapes and all share the common feature of capturing a segment of the total market. There are Major Stock Market Indices that use price or market capitalization of a sampling of stocks that are theoretically representative of a global, national, or regional economy. There are specific Sector Indexes based on standard industrial classification groupings that attempt to represent the performances of different business classes within an economy. Indices can serve as guides that investors can use to spot economic and market trends and as tools to help investors pick specific stocks for buying and selling.

Summary:

P

A Stock Market Index is used as a way to measure the value of a segment of the total market. Major indices—like the DJIA, the S&P 500, and the FTSE 100—group a sampling of large-cap stocks to allow an approximate gauge of a national economy.

 

P

Stock Market Indices use the share price or the market capitalization of index components to calculate the total value of the index. With a Price-Weighted Index, a company with a smaller market cap can have a greater impact on the index value if it has a higher share price; in a Market-Cap Weighted Index the largest companies have the greatest effect.

 

P

Although there are some drawbacks in all major indices, tracking the percentage change over a period of time allows investors to see stock market trends, both rising and falling.

 

P

Sector Indices offer a buying and selling road map for all types of investors. Investors who like going with a rising tide can look into the stocks in sectors that are outperforming, while bargain-hunting investors can look for “best of breed” stocks in weaker sectors.

  

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