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Stock Market Indices

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Stock market indices provide a useful tool to summarize the vast array of information generated by the continuous buying and selling of stocks. However, the use of market indices presents two problems. First, many different indices compete for attention. Second, indices differ in their composition and can give contradictory information regarding price movements of the stock market.

When constructing a stock market index, the base value and the starting date have to be selected. Only the relative changes in the index values are useful. For example, knowing only that a particular stock market index finished the year at a level of 354.7 is of no value. But if you also know that the same index finished the previous year at a level of 331.5, then you can calculate that the stock market, as measured by this particular index, rose approximately 7 percent over the past year.

The next decision is which stocks should be included in the index. There are three methods for deciding stock market composition: (1) the index can represent a stock exchange and include all the stocks traded on the exchange, (2) the organization producing the index can subjectively select the stocks to be included, or (3) the stocks to be included can be selected based on some objective measure such as market value. Often an index represents the performance of various industry segments such as industrial, transportation, or utilities. Once the stocks to be included in an index are selected, the stocks must be combined in certain proportions to construct the index. Each stock, therefore, must be assigned some relative weight, usually by share price or market value of the company.

Price-Weighted Indices

A price-weighted index is computed by summing the prices of the individual stocks in the index. Then the sum of the prices is divided by a divisor to yield the chosen base index value. Thereafter, as the stock prices change, the divisor remains constant. For example, if the price per share of three stocks in a price-weighted index were $20, $10, and $50 respectively, then the prices would sum to $80. If the base index value is to be 100, then the initial divisor would be 0.8 because 100 = 80/0.8. On the next trading day, say prices per share of the stocks change to $25, $10, and $40. Now the new sum of share prices would be $75 and the price weighted index value would be 75/0.8 = 93.75 or 6.25 percent lower.

Market Value-Weighted Indices

A market value-weighted index is computed by calculating the total market value of the firms in the index and the total market value of those firms on the previous trading day. The percentage change in the total market value from one day to the next represents the change in the index. For example, if the three stocks described in the example above had outstanding shares of 100 million, 200 million, and 10 million, then the total market value for the three stocks on the first day would be $4.5 billion. The total market value on the second day would be $4.9 billion, for an increase of 8.8 percent. If the market value-weighted index began with a a base index value of 10 on the first day, then its value on the second day would be 10.88, or 8.8 percent higher.

Dow Jones Averages

The most widely cited stock market index is the Dow Jones Industrial Average (DJIA) which was first published in 1896. The DJIA is a price-weighted index that originally consisted of 20 stocks with a divisor of 20; this means that the value of the index was simply the average price of the original 20 stocks. In 1928, the DJIA grew to encompass 30 of the largest U.S. industrial stocks and includes today such companies as Verizon, Dupont, and Merck.

New York Stock Exchange Index

The New York Stock Exchange Index, published since 1966, includes all of the common and preferred stocks listed on the NYSE. In addition to the composite index, the NYSE stocks are divided into four sub-indices that track the performance of industrial, utility, finance, and transportation stocks. All the NYSE indices are market-value weighted.

Standard and Poor's Indices

The Standard and Poor's (S&P) 500 Index is a value-weighted index that consists of 500 of the largest U.S. stocks from various industries. The stocks included in the S&P 500 account for over 80 percent of all the stocks listed on the NYSE, although a few NASDAQ issues are also included. The index is computed on a continuous basis during the trading day. It is divided into two sub-indices that follow the performance of industrial and utilities companies.

The S&P 400 MidCap Index is market-value weighted and consists of 400 stocks with market values less than those of the stocks in the S&P 500. The S&P 400 MidCap index is useful for following the performance of medium-sized companies.

The S&P 600 SmallCap Index tracks 600 companies with market values less than those of the companies in its S&P 400 MidCap index. The S&P 1500 index includes all of the companies in the S&P 500, the MidCap 400, and the SmallCap 600. NASDAQ Indices The NASDAQ Composite has been compiled since 1971. It consists of three categories of companies: industrial, banks, and insurance. All of the stocks traded through the NASDAQ are included. In 1984, the NASDAQ introduced two new indices, the NASDAQ/ NMS Composite index and the NASDAQ/ NMS Industrial Index. Both are weighted by market capitalization.