The major stock indexes provide a significant amount of information with just a few numbers. In chapter seven of “Stocks for the Long Run,” author Jeremy Siegel set out to explain what is behind the numbers so many investors and others watch.
The Dow Jones Industrial Average
Known simply as “the Dow” or even “the stock market,” this average is ubiquitous, even though it is no longer the best overall indicator of stock market movements. First published by Charles Dow in 1885, it focused originally on industrial stocks, as the name suggests. The original followed mostly railroads, but then became more associated with industrial and manufacturing companies.
As of 2013, the Dow included 30 stocks, including names as diverse as Caterpillar (CAT, Financial), Coca-Cola (KO, Financial) and Pfizer (PFE, Financial). So, although it still contains a few industrial and manufacturing names, it now takes in most major American industries.
Originally, the index was calculated by dividing the sum of the prices by the number of stocks in it. This means it is a price-weighted index, which means “proportional movements of high-priced stocks in the Dow averages have a much greater impact than movements of lower-priced stocks, regardless of the size of the company. In November 2013, Visa, with a market price of $200 a share, constitutes more than 8 percent of the index, while Cisco, the lowest-priced stock, has a weight of less than 1 percent.”
Also, in late 2013, the Dow stocks represented about 25% of the capitalization of all publicly traded U.S. stocks. Among notable absentees from this index at the time were Apple (AAPL, Financial) and Alphabet's Google (GOOG, Financial). Siegel added that the Dow, like the other indexes, does not include dividends, and thus understates the actual total return. When they are included, the total annual real compound return has averaged 6.2% per year since 1885.
The Standard and Poor’s Index
Unlike the Dow Jones Industrial Average, the S&P 500 and the Nasdaq are value-weighted indexes, which means these exchanges base their valuations on their performance weighted by their capitalization or market value. On the other hand, the Dow weights its valuations on stock prices. Siegel said, “Capitalization weighting is now recognized as giving the best indication of the return on the overall market, and it is almost universally used in establishing market benchmarks.”
The S&P 500 index was first published in 1923 with 90 stocks, but was expanded to 500 stocks in 1957. At that time, it included about 90% of the capitalization of all stocks listed on the New York Stock Exchange. By the end of 2012, the index had come to represent less than 75% of the value of all companies traded in the United States.
Siegel called it the “world standard for measuring the performance for stocks.” It has also become the standard against which many fund managers and others are judged.
Over time, the S&P 500 evolved as existing companies were lapped by better-performing new companies, based on criteria including market value, earnings and liquidity. On average, about 20 companies are replaced each year, and they constitute about 5% of the market value.
The composition of the index also reflects the evolution of the American economy. When the index first appeared 61 years ago, its prominent components were in the steel, chemical, auto and oil industries. In 2013, it was dominated by health care, technology, finance and consumer services companies. Siegel added:
“The study of the original 500 companies also gives you an appreciation of the dramatic changes that the U.S. economy has undergone in the past half century. Although, many of the top performers are producing the same brands that they did 50 years earlier, most have aggressively expanded their franchise internationally. Brands such as Heinz ketchup, Coca-Cola, Pepsi-Cola, and Tootsie Roll are as profitable today as they were when these products were launched, some over a hundred years ago.”
The Nasdaq Index
When the National Association of Securities Dealers Automated Quotations operations began in 1971, it wasn’t just another exchange—it was an automated quotation system that revolutionized trading. It offered “bid” and “ask” prices for 2,400 leading, over-the-counter stocks. In general, this meant it was handling smaller or newer companies that did not meet the listing standards of the big exchanges.
One of the implications was that it became the home of what were to become the giant tech stocks, including Microsoft (MSFT) and Intel (INTC). These stocks drove the Nasdaq very high, very quickly in the late 1990s. That, in turn, attracted many other companies, and a virtuous circle emerged (at least for a time).
Thanks to the tech boom of the 1990s, the Nasdaq’s values grew in leaps and bounds—into a bubble. It doubled from 1,000 to 2,000 in just three years. Most notably, it increased from 2,700 in October 1999 to an all-time peak of 5,049 in March 2000, a jump of 87% in about six months.
Of course, the bubble burst and the index fell to 1,150 by October 2002. By the end of 2012, 10 years later, the Nasdaq has risen to 3,000. On the last day of 2018, it was up to 6,635.
Nasdaq also won the battle that saw its automated trading system take on the “floor trading” used by other exchanges. Market makers and shouting traders have been largely replaced by electronic data.
The bias issue
Some investors believe that weighted indexes such as the S&P 500 will show returns that are greater than investors can achieve because of turnover of firms within the index. Siegel argued this is not true, because the index will hold not only the very best growth stocks, but also the “fallen angels” that have been removed from the large-cap indexes and are headed down.
He added:
“An index is not biased if its performance can be replicated or matched by an investor. To replicate an index, the date of additions and deletions to the index must be announced in advance so that new stocks can be bought and deleted stocks can be sold. This is particularly important for issues that enter into bankruptcy: the postbankrupt price (which might be zero) must be factored into the index. All the major stock indexes, such as Standard & Poor’s, Dow Jones, and the Nasdaq, can be replicated by investors. Consequently, there is no statistical reason to believe that these indexes give a biased representation of the return on the market.”
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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