Choosing the Best Stock Market Index Econoday Focal Point 5/15/00 By Evelina Tainer, Chief Economist

Market Indices Are Different and Behave Differently over Time

Whether you are a day trader or a long-term investor, routinely checking stock market activity has now become commonplace. The great 1990s bull market coupled with rapidly appreciating employer-sponsored 401(k) plans has generated strong interest from average households for market information and daily stock price movements.

The popular press quotes hourly changes in the Dow Jones Industrial Average, making it, despite building interest in the NASDAQ composite, the indicator of choice for new stock market investors. Individuals realize that the value of their portfolios rise as the Dow ramps up. Conversely, when the Dow plunges, individual investors no doubt worry that their portfolios are taking a beating.

Yet individual investors are probably surprised to see that the gains or losses in their portfolios don’t always approach the market average. In other cases, they see their portfolio move more dramatically than would be indicated by the Dow. So what gives?

Stock activity varies by market. Depending on which particular index you quoted, you might have described the 1999 equity market as phenomenal (NASDAQ composite jumped 85.6 percent) or simply good (Dow Jones Industrials rose 24.2 percent). Individuals investing in foreign markets have seen diversity in the past few years. For instance, emerging markets collapsed in 1997 when turmoil in Southeast Asia caused panic in the streets (literally). Problems in Russia and Latin American economies roiled the markets in 1998. Individuals investing in global markets might have been hit in 1997 and 1998, but saw a good recovery in 1999. Furthermore, if investors also held U.S. Treasury securities in their portfolios, the losses might have been mitigated. Treasury bonds saw tremendous appreciation in mid-1998. Diversification pays.

Individual investors who use the Dow Jones Industrial Average (DJIA) as a proxy for their own portfolio must find it misleading to say the least. Indeed, "the stock market" consists of more than 30 blue chip companies. Investors need to monitor other benchmark indices to gauge the performance of their own mutual funds and portfolios more accurately.

In reality, stock market indicators abound. You may be surprised to learn that they don’t all move in the same direction or by the same magnitude at all times. You will find that some of the indices, other than the DJIA, may be more aligned to your particular portfolio and give you a better reading of where you stand.

The Dow Jones Family
The Dow Jones Industrial Average of 30 blue chip companies is designed to measure the pulse of the largest companies in the United States, considered representative of the nation’s economy. The average includes typical industrial companies such as General Motors (GM) and Minnesota Manufacturing & Mining (3M). The DJIA also includes Walt Disney and Sears Roebuck, which are not considered "industrial" in the traditional sense. The basic premise behind the Dow is that it represents broad economic trends. It does, but the U.S. economy is more complex than it was in the 19^th century when the index was first compiled. Market mavens have started to call this index a measure of "old economy" stocks.

The DJIA is a price-weighted index. This means that companies with high stock prices have greater influence on changes in the index than companies with lower prices. The index is a sum of company prices divided by a "divisor" intended to account for stock splits.

The Dow Jones Transportation indices measure stock prices of 20 railroad, airline and trucking companies. The DJTI is considered a leading indicator of changes in the DJIA. The Dow Jones Utilities Index measures stock prices of 15 utility companies and tends to be more sensitive to changes in interest rates than the Industrials or Transports because utility companies have historically offered high dividend returns.

The S&P Family
The DJIA may be more widely quoted, but the S&P 500 index is a more comprehensive measure of market activity. The 500 companies are chosen not for their size but because they are leading companies in leading U.S. industries. Of the companies currently listed in the index, 89.2 percent trade on the New York Stock Exchange (NYSE) and 10.8 percent in the NASDAQ market. This index is weighted by market value (stock price times the number of shares outstanding) rather than (stock) price only. In contrast to the Dow, where companies with high stock prices have greater influence on changes in the index, companies with larger market capitalization have greater influence on changes in the S&P 500.

The S&P 500 can be divided into various groupings. The four main industry groups include industrials (75.6 percent), utilities (8 percent), financials (14.2 percent), and transportation (2.2 percent). The 500 index can also be divided into economic sector groupings: basic materials, capital goods, communication services, consumer cyclicals, consumer staples, energy, financial, health care, technology, transportation, and utilities. These classifications are typically used by financial professionals to target sectors in which to invest over different stages of the economic business cycle. At the end of 1999, the three sectors with the largest representation in this index were consumer cyclicals (16.2 percent); financial (14.4 percent) and technology (13.6 percent). One final (S&P) classification is between growth and value stocks. The value index (46 percent) contains companies with lower price-to-book ratios, while the growth index (54 percent) contains those with higher ratios. Incidentally, since the growth stocks have higher market capitalization, they are fewer in number than the value stocks (which have a smaller market capitalization).

Many mutual fund companies have designed index funds to mirror the S&P 500. After accounting for (usually small) management fees, the index funds move in tandem with the S&P 500.

Stock Exchange Measures
The NASDAQ composite index is cap-weighted (market capitalization) and measures the performance of this stock market. At the end of March 2000, about 4800 companies were listed. This market is generally home to smaller stocks than the New York Stock Exchange. The NASDAQ market tends to list fast growing technology companies, with Microsoft and Intel two such examples. But it is more usual to see small, lesser-known names in this index.

While the composite index is more widely quoted, the NASDAQ market can also be divided into various sectors such as industrials, financials (banks, insurance and other financial industries), transportation, computers and biotechnology. Also the NASDAQ-100 is traded (QQQ) on the American Stock Exchange.

The NASDAQ composite index is widely followed these days due to its concentration of popular technology issues.

The New York Stock Exchange (NYSE) reports a composite index of all its listed stocks. It is a cap-weighted index of roughly 3100 companies. Subindexes are calculated for industrial, transportation, utility and financial companies listed on the NYSE, also known as the "Big Board". The American Stock Exchange also calculates a market value index of its nearly 800 listed stocks.

Private Companies Compile Index Information
Clearly, the composite indices from the various exchanges don’t quite tell a complete story. Looking at the Dow and the S&P 500 can also be misleading if investors have portfolios with small cap (small capitalization) stocks. Consequently, private investment analysis firms have developed a variety of indicators to be used as benchmarks. The Russell 2000 index and the Wilshire 5000 are two measures that attract wide audiences among investment professionals as well as individual investors, government policymakers and the media.

The Russell 2000 is the best-known small-cap index. It includes 2000 companies (hence the name). About half of the companies are listed in the NYSE and just under half are listed on the NASDAQ (the remaining come from the AMEX). The companies are the bottom 2000 of the Russell 3000, which are the top 3000 companies in the NYSE, AMEX and NASDAQ headquartered in the United States and ranked by market capitalization. The average market cap for companies in the Russell 2000 is less than $600 million.

The Russell 2000 is widely quoted in the financial press. It is less well known that the Russell set of indices is quite extensive. For instance, Russell compiles value versus growth indices for each of its 1000, 2000, 2500, and 3000 series. It compiles mid-cap indices as well.

The Wilshire 5000 is the broadest measure of market indices since it includes prices of all U.S. stocks traded on each of the exchanges. While there were 5000 issues in 1970, when this index was first compiled, there are roughly 7600 traded companies headquartered in the United States today. Market professionals watch this index more closely than individual investors do; the index tends to get less attention in the popular and even in the financial press. At the February Humphrey-Hawkins testimony, Federal Reserve Chairman Alan Greenspan indicated that this is the specific stock index he follows since it broadly represents the stock market.

In the past year, several mutual fund companies have designed index funds to mirror this broad measure of the U.S. stock market. Consider this, when investors rotate out of high tech stocks into old economy blue chips, the overall market might not change much. However, if you were holding only a NASDAQ-100 index and not an S&P 500-index fund, you might see losses in your portfolio without the requisite gains.

The Wilshire 5000 can be divided into nine sectors. These are capital goods, consumer durables, consumer nondurables, energy, finance, materials & services, technology, transportation, and utilities. The materials & services category is the largest component of the Wilshire in terms of number of companies (25 percent). However, technology is the largest sector by market capitalization (32.8 percent). Looking at the composition of the Wilshire 5000 by exchange, the largest number of companies come from the NASDAQ (69.8 percent), but by market capitalization, the NYSE is greatest (55.6 percent).

THE BOTTOM LINE
Investors might use a more comprehensive benchmark to compare their portfolio or mutual fund returns than simply the Dow Jones Industrial Average or even the S&P 500. In the past year, surveys of consumer expectations have shown that individual investors tend to have inflated expectations of annual returns that have little to do with long term historical reality. These consumers are simply extrapolating the returns (in the Dow or the S&P or the NASDAQ) of the past three years. These "hefty" returns would have diminished if they were watching the broader market.

You will find that mutual fund companies tend to compare specific funds to a variety of benchmarks. For instance, mutual funds investing with a growth objective might compare their returns to the Russell 2000 growth index. Similarly, funds investing with a value objective might use the Russell 2000 value index.

If you are investing in an index fund intended to mirror the S&P 500, by all means use that as your benchmark. Otherwise, look at other measures that more accurately reflect the overall market. These will give you a better sense of the underlying performance of your portfolio relative to the total market. It will make you less likely to shift in and out of funds just to catch the latest "hot" fund. By less shifting of funds, you will be able to reduce your transaction costs and enhance your returns in the long run.