Value Line is regarded as the best independent research available. More than just recommendations, Value Line provides the rationale behind its picks for greater understanding.
- Don D., California
Assessing the Stock Market – A Look at the Major Indexes
Stock indexes attempt to summarize the performance of a group of stocks in a single number. Many providers publish indexes of segments as small as the stocks in a single industry in one country, to one that follows all publicly held stocks in the U.S. The four American indexes most referred to by American stock market gurus are the Dow Jones Industrial Average, the Standard & Poor’s 500 Index, the NASDAQ, and the Russell 2000, a small-stock subset of the Russell 3000. For reasons outlined below, we think the Value Line (Arithmetic) Index is better than all of these as a proxy for the entire North American stock market, which is the universe of stocks that the average small investor can easily trade in the U.S. Before we toot our own horn, herewith a few words about the other indexes.
The Dow Jones Industrial Average, now administered by a joint venture of News Corp. (NWS) and CME Group (CME), consists of 30 U.S. headquartered companies that cover all industrial sectors but transportation and utilities, which have their own Dow Jones indexes. Thus, the DJIA attempts to represent most of the U.S. economy and does not include only huge-cap stocks, as it needs representation in eight sectors. The index (not, strictly speaking, an average) is price-weighted; that is, the importance of a stock to movements in the “Dow” depends on its absolute price, adjusted for stock splits. The Dow index reading is calculated by adding the prices of the 30 components and dividing by a divisor that is calculated to adjust the DJIA for stock splits and changes in its makeup. Historically, the 30 stocks in the Dow have accounted for about 25% of the total market capitalization of all U.S. stocks.
Standard & Poor’s, a division of The McGraw-Hill Companies, (MHP), publishes dozens of stock and fixed-income indexes, domestic and foreign. Its best-known is the S&P 500-stock index, which includes only U.S. based companies, generally the largest, but it may include smaller companies in an effort to achieve a representative industry balance. Criteria for adding a stock include such things as a market cap of at least $4 billion and a public float of at least 50% of the shares. The index is market-capitalization weighted, which means that the largest ten stocks account for about 19% of the index. Standard & Poor’s also publishes an equally weighted version of the 500, and a comparison of the returns of the two is instructive. The equally-weighted version has done better than the regular 500 over all recent time spans, indicating stronger relative performance by smaller stocks. Over the last 10 years, the S&P 500 had a total annual return of 2.62%, versus the equally weighted annual gain of 6.96%. This out-performance of the smaller names has helped many a fund manager do better than the S&P 500, which is used as a benchmark by over a trillion dollars of equity investments.
The NASDAQ consists of over 3,000 domestic and international stocks traded exclusively on the NASDAQ STOCK Market. Thus, the two largest mutually exclusive groups of stocks in the U.S. are the NASDAQ and the New York Stock Exchange index. Like the S&P 500, the NASDAQ is market capitalization weighted. Its largest companies are technology names, lending substance to its oft-used modifier “tech-heavy”.
The Russell 3,000 stock index, and its 1,000- and 2,000-stock constituents, are administered by Russell Investments, a subsidiary of Northwestern Mutual Life Company. Since investors look to the S&P 500 as an indication of large-company performance, the Russell 2000 Small-Cap Index gets more attention than the Russell 1000. Like the S&P 500, the 2000 is market-cap weighted, but unlike the S&P, it contains foreign stocks traded in the U.S.
Finally, the most common estimate of the total U.S. stock market is provided by the Wilshire 5000 Total Market Index of the largest 5,000 publicly traded companies. Like the S&P, the Wilshire excludes foreign stocks. Moreover, the smallest 2,000 of the index account for just a few percent of the total market capitalization of all stocks, and some have very little liquidity.
The Value Line Investment Survey includes roughly the 1,700 largest stocks, by market capitalization, traded in the United States, grouped into around 100 industries. It includes a total of around 80 American Depositary Receipts (ADRs), Canadian stocks, and foreign stock funds that can be bought on U.S. exchanges. To be included in the Investment Survey, a stock generally needs a market capitalization of at least $250 million, annual revenues of $50 million, and a tradable “float’’, i.e. shares not held by insiders, of at least 10 million shares. The Value Line (Arithmetic) Index is the only “equally weighted” major index; that means that all the components count the same in calculating the total. In other words, on a day when all stocks but Exxon Mobil (XOM - Free Exxon Stock Report) and the smallest company in the survey are unchanged, and these two stocks move in opposite directions by the same percentage, the index number does not change.
We believe that the Value Line (Arithmetic) Index is the best single estimate of “the” U.S. stock market for several reasons. Unlike the Dow Jones Industrials and the Standard & Poor’s 500-stock indexes, it includes foreign stocks that can be traded easily in the U.S. More important, its equal weighting gives equal importance to all its components, unlike all the other indexes. That is important, because most investors do not have to limit their portfolios to large companies, since the average investor does not face the same liquidity issues as bigger investors, such as mutual funds. And since the average investor has relatively small positions in each stock held, he or she can trade the smallest companies in the Investment Survey without fear of affecting the price of the stock and benefit from the price movements of securities that larger investors likely couldn’t trade. Since the Value Line (Arithmetic) Index captures these movements better than the other indexes, we believe it is more representative of what individual investors experience.
At the time of this article’s writing, the author owned shares of Exxon Mobil and Microsoft.