Stock Indexes, U.S.
A stock index simply represents a basket of underlying stocks. Indices can be either price-weighted or capitalization-weighted. In a price-weighted index, such as the Dow Jones Industrials Average, the price of each of the stocks are simply added up and then divided by a divisor, meaning that stocks with higher prices have a higher weighting in the index value. In a capitalization-weighted index, such as the Standard and Poor's 500 index, the weighting of each stock corresponds to the size of the company as determined by its capitalization (i.e., the total dollar value of its stock). Stock indices cover a variety of different sectors. For example, the Dow Jones Industrials Average contains 30 blue-chip stocks that represent the industrial sector. The S&P 500 index includes 500 of the largest blue-chip U.S. companies. The NYSE index includes all the stocks that trade at the New York Stock Exchange. The Nasdaq 100 includes the largest 100 companies that trade on the Nasdaq Exchange. The most popular U.S. stock index futures contract is the S&P 500 at the Chicago Mercantile Exchange (CME).
Prices - The S&P 500 index in 2007 posted a new record high but then faded late in the year to close only +3.2% higher on the year. The S&P 500 squeaked out its fifth consecutive yearly gain (2007 +3.5%, 2006 +13.6%, 2005 +3.0%, 2004 +9.0%, 2003 +26.4%). The S&P on its record high of 1576.09 posted in October 2007 rallied by a total of 105% from the 2000-02 bear market low of 768.63 posted in October 2002. However, the S&P 500 index faded late in 2007 and then sold-off sharply in January 2008 for an overall downward correction of -19.4% from October's record high.
The U.S. stock market in 2007 was boosted by strong U.S. earnings growth of about 10% excluding the financial sector. However, including financial sector losses from the credit crisis, annual earnings growth in 2007 for all the S&P 500 companies fell by about 2%, ending four consecutive years of double-digit earnings growth (2006 +16.5%, 2005 +13.7%, 2004 +20.2%, 2003 +18.4%), according to Thomson Financial. The double-digit earnings growth seen in 2003-06 was an extraordinary performance for earnings growth and was far in excess of the 25-year average for S&P 500 earnings growth of +8.6%.
The strong earnings performance by non-financial U.S. corporations kept valuations reasonable during 2007 and supported stock prices. The S&P 500 forward price/earnings ratio (based on forward-looking earnings) averaged about 15 during 2007, which was below the 3-year average of 16.6 and the 10-year average of 19.8.
The U.S. stock market was also supported in 2007 by strong U.S. GDP growth in Q2 and Q3 2007 and by stronger overseas GDP growth, which boosted exports. The U.S. stock market initially sold off when the credit crisis began in earnest in August 2007, but then rebounded to a new record high in October as the market initially thought the Fed's rate cuts would keep the credit crunch contained. However, the U.S. housing sector continued to deteriorate through year-end and the credit crunch progressively claimed more victims, leading to a sell-off in the stock market in the fourth quarter of 2007. The stock market then sold off further in January 2008 as it became clear that the U.S. economy was under serious threat. In early March 2008, the situation was grim as the economic data suggested that the U.S. economy might have already entered a recession in Q1. In addition, the credit crunch in mid-March 2008 claimed its largest victim yet as Bear Stearns required a bank bailout arranged by the U.S. Federal Reserve.