Are stock indexes a good barometer?

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

you think.

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

percent.

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

a disparity.

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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