FCW's Friday Financials column takes a look at how well various stock indexes reflect how well the market is doing
There's a lot more behind the question "How did the market do today?" than
By the market, most of us generally mean the major indexes such as the Dow
Jones industrial average, the Nasdaq and the S&P 500 index. If these
indexes are "up," we consider "the market" to be up. If someone asks, "How
did the market do today?" we usually respond by describing the performance
of the Do
But are these indexes reflective of the overall performance of the market?
The Dow and the S&P 500 are "capitalization weighted," meaning that
the total market value of each stock has a proportionate bearing on the
index's performance. For example, if two of the stocks in the Dow are both
up in price today by $2, they will not have an equal impact on today's Dow
Jones industrial average. Each stock in the average has its own "weight,"
reflecting the ratio of its total market capitalization to the total market
capitalization of all 30 Dow Jones industrial average stoc
For example, a "smaller" company with say, a $20 billion market capitalization,
won't have the same impact on the Dow as will a company with a $60 billion
market capitalization. The $60 billion market cap company will carry triple
the weight of the $20 billion market cap company.
The S&P 500 index works the same way. Although the "market," as measured
by these market capitalization weighted indices, is up substantially since
1995, a quite different picture emerges if one examines the performance
of U.S. equities without differentiating between larger and smaller companie
Even the S&P 500, which depicts the performance of the 500 largest companies
(based on market capitalization), presents an uneven picture when one compares
the performance of the top 50 companies with the remaining 450 companies.
For example, on June 30, 1998, companies with a market capitalization of
less than $250 million had an average decline from their 52-week high of
about 40 percen
At the same time, 60 percent of Nasdaq companies were more than 20 percent
below their 52-week highs, and 45 percent were more than 30 percent below
their 52-week highs. Yet, the overall Nasdaq average was up more than 17
Even more telling is data recently compiled by Salomon Smith Barney Inc.
On July 29, 1998, the average New York Stock Exchange stock was down 24.3
percent from its 52-week high. On Nasdaq, the average stock had declined
an even more dramatic 35 percent. Meanwhile, the Dow showed a 12 percent
gain in 1998, and the Nasdaq index reflected a gain of 19 percent.
Does such data suggest that the "market" is really up? The answer to that
question depends on how you define "the market." At the same time that most
stocks, as noted above, were declining in value, companies whose market
capitalization was greater than $20 billion experienced an average decline
from their 52-week high of only 9.2 percent. The latter group, on average,
has seen its stock appreciate by 16.62 percent during the preceding year,
but the group with a market cap of $250 million or less suffered an average
decline in its share price during the preceding year of 1.95 percent. Quite
All available information suggests that recent advances in the equity markets
(since 1996) have been largely confined to large-cap companies. Before 1996,
small-cap companies performed well relative to large-cap companies. That
year, the trend reversed and the disparity in performance between large-cap
and small-cap companies has widened. While many indexes were hitting new
records, a large percentage of stocks experienced significant declines.
For a large number of Nasdaq stocks, the bear market has arrived.
To use an index properly, you must first answer the basic question, "What
am I trying to measure?" If you are content to accept the characterization
of "the market" as the largest companies, then the indexes currently used
to measure market performance, for example, the S&P 500 or the Dow,
are quite adequate. For investors in large-cap stocks or index funds, these
indexes do accurately measure performance in a meaningful wa
However, for investors in small-cap stocks who may want to know how stocks
of U.S. companies are performing without regard to company size and market
capitalization, the Dow Jones industrial average and the S&P 500 index
are not the best yardsticks for this purpose. The Russell 2000 would appear
to be the preferred measure or yardstic
The Russell 2000 is one of the better-known indexes used to measure the
stock performance of small U.S. companies. To construct the index, the Frank
Russell Co. first constructs the Russell 3000 index by selecting the 3,000
largest companies with headquarters in the United States. The 1,000 largest
stocks become the Russell 1000, and the remaining stocks become the Russell
2000. The Russell 1000 is not very different from the S&P 50
Even investors in Nasdaq stocks should be wary of the Nasdaq index, which
is also capitalization weighted. Some of the largest technology companies
such as Intel Corp., Microsoft Corp. and Dell Computer Corp. dominate. Unless
you are an investor in those companies, the Nasdaq index will not tell you
much about how your over-the-counter investment is doing.
Improper use of indexes to measure relative performance can produce misleading
information. Using the proper index to gauge performance is crucial to making
intelligent investment decisions.
— Zall, Bureaucratus columnist and a retired federal employee, is a freelance
writer based in Silver Spring, Md. He specializes in taxes, investing, business
and government workplace issues. He is a certified internal auditor and
a registered investment adviser.
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