- 2000: Volume 9, No. 2 Straight Talk on Indexes

The Dow Jones Industrial Average is the most widely followed index in the world. Developed by Charles Dow in 1896, this popular index was designed to gauge business trends within the U.S. economy by tracking the price performance of 12 well-known companies. In the process, Dow authenticated what bankers and other financial professionals already knew: stock prices of major U.S. companies tend to move together. With the passage of time, the Dow Jones Industrial Average has become the quintessential barometer of stock market activity. The media consistently refers to "the Dow" when reporting on the daily performance of the U.S. stock market. Since thinking about the market in terms of individual stocks is a cumbersome activity-especially for investors with large portfolios-the Dow offers investors the means to measure the markets as a composite group of popular stocks. Today's Dow consists of 30 stocks, continually modified to best reflect the current trends in the U.S. economy. In 1999, for example, chipmaker Intel and software maker Microsoft were added to the index to better reflect the growing role of technology in the national economy. These days, when someone asks about the stock market, the answer will more than likely start with a reference to the oldest and most closely watched index in the world, the Dow Jones Industrial Average.

Through the years, in an effort to supply stock market watchers with a composite of stock market performance, other financial publications and investment firms have developed indexes or indexes. The list is too long to mention, but a few are worth noting including:

• The Standard & Poor 500: The S&P 500 is the favored benchmark of market performance by institutional investors. The 500-stock index measures the aggregate stock price performance for 400 industrial, 40 utility, 40 financial, and 20 transportation companies.
• The Standard & Poor 100: Known by its ticker, OEX, the S&P 100 is an index of 100 large U.S. companies from a diverse group of industries.
• The NASDAQ Composite (NASDAQ): The NASDAQ Composite indicates the price movement of most over-the-counter stocks listed on the NASDAQ.
• The NASDAQ 100 (NDX): NDX is an index representing 100 of the largest, non-financial companies trading on the NASDAQ.
• The Russell 2000 Small Cap Index (RUT): Often referred to as the Russell, this index tracks the performance of the bottom 2000 companies from the largest 3000 traded on the NYSE, NASDAQ, and AMEX. It is the most widely followed measure for the performance of smaller companies.

Each of these indexes differs in certain respects and offers a unique perspective on the performance of the stock market. The S&P 500, for example, includes a much larger group of companies than the Dow, and therefore, usually provides a better gauge of the overall activity within the market.

Sometimes, the performance of two indexes will diverge. For example, the chart below shows the relative performance of the Dow Jones Industrial Average and the S&P 100. As one can see, both hit high levels simultaneously on January 14, 2000. Since then, both have been in a downward trend or a bearish market. Yet, while the Dow Jones Industrial Average (INDU on the chart) lost roughly 16 percent in value during the decline, the S&P 100 (OEX) fell a more modest 6 percent. Given that both indexes track the performance of large U.S. companies, how does one account for the much larger drop in the Dow Jones Industrial Average?

Figure 1

One factor to consider when studying an index is its relative exposure to various economic sectors. The stocks or components of each index can be grouped into industry groups or sectors. There are a number of ways of doing so, but one of the most amenable is the 11 economic sectors created by Standard & Poor: basic materials, energy, capital goods, transportation, communication services, financials, healthcare, consumer staples, consumer cyclical, utilities, and technology.

Since each index measures the performance of a unique group of stocks, each one possesses a distinctive exposure to the 11 economic sectors. For example, while 20 percent of the Dow Jones Industrial Average consists of technology shares, approximately 35 percent of S&P 100 companies are technology-related.

The recent performance of the 11 economic sectors can also be studied using indexes. Just as the S&P 500 provides a gauge for the overall stock market, there are also indexes which track the performance of specific sectors or industry groups. For example, a chart of the Morgan Stanley High Technology (MSH) index provides an accurate representation of the happenings within the technology sector. There is a wide array of sector and industry group indexes. One place to go to find lists and descriptions of sector indexes is the stock or options exchanges including the American Stock Exchange (amex.com), the Philadelphia Stock Exchange (phlx.com), or the Chicago Board Options Exchange (cboe.com).

If there isn't an index that accurately reflects a particular group or sector, you can always create one using historical data. To create an index, simply add the prices of a group of stocks together and then divide the sum of the stock prices by a divisor. The divisor is an arbitrary number used to set the index to a specified value. A round number like 100 works well. For example, since there is no index (to my knowledge) that reflects the capital goods sector, I created one by adding the share prices of stocks within the capital goods sector using companies like United Technologies, Honeywell, Boeing, etc. from 1995 to the present.

Figure 2 provides the calculations of a simplified example of index creation. The stock prices of three stocks are added together on January 1995 and a divisor is created to set the index value to 100. As the stock prices change, the divisor is used to update the value of the index. So, in March 2000, as the sum of the stock prices has increased from 255 to 336, the index value has risen from 100 to 143.54. This type of index is referred to as a price-weighted index.

Figure 2:

Basic Index Calculations
Stock	Price (Jan 1995)	Price (Mar 2000)
XYZ ABC ZYX SUM DIVISOR INDEX VALUE	75 + 100 + 80 255 X .3922 100	100 + 125 + 111 336 X .3922 143.54

The Dow Jones Industrial Average is a prime example of a price-weighted index. In contrast, the S&P indexes are capitalization-weighted. Capitalization refers to the market value of a company (number of shares trading multiplied by the current market price for common stock). In a cap-weighted index, the total market values of the stocks within the index are added together. The total of the market values is then divided by a divisor to arrive at the index value. Whether an index is price or cap-weighted is an important consideration when analyzing its performance.

After indexes are identified (or created) to represent each of the 11 economic sectors, it becomes possible to shed light on what is happening within the market. Figure 3 shows the 11 sectors along with the indexes used to study each group. For example, while the Morgan Stanley Consumer Index provides a fair representation of the consumer staples sector, the Morgan Stanley Cyclical index provides a proxy for the cyclical group.

Each sector index, in turn, can be viewed using stock charts to gauge the overall trends. I consider a sector's trend to be negative, or in a bear market, if the index is 20 percent or more from its all-time high and has, in the year 2000, penetrated its 1999 closing low. Therefore, of the 11 economic sectors, five currently show signs of a declining or bear market including financials, consumer staples, healthcare (except Biotech), utilities, and transports. Studying the table will also reveal that the best performing sector was the technology group-MS High Technology index added 12.66 percent for the year.

Finally, Figure 3 also shows how the Dow Jones Industrial Average (percent of INDU) and S&P 100 (percent of OEX) differ in terms of exposure to economic sectors. For example, while 21.3 percent of the Dow Jones Industrial Average stocks are technology-related (International Business Machines, Microsoft, Intel, etc.), 35 percent of the OEX falls within that sector. Let's return to the question posed earlier: Why did the Dow drop more than the S&P 100 during the recent market drop? Part of the answer lies in the fact that the OEX has a greater exposure to the top performing sector so far this year- i.e. the technology sector.

Figure 3

The Dow Jones Industrial Average may be the oldest and most widely followed index, but market diversity requires investors to keep a close watch on a variety of indexes. As the number of indexes mushrooms, each index offers a unique view of the market. Just as with individual stocks, sometimes indexes move together, and sometimes not. For example, although OEX and the Dow Jones Industrial Average represent large U.S. companies, there has been a divergence in their recent performances. To understand why, it is useful to dissect the index and consider which individual stocks and economic sectors weigh heaviest within the index. By doing so, the investor is better equipped to see what is happening below the surface of the U.S. stock market and thus, make better trading decisions.

Frederic Ruffy is a senior writer for www.optionetics.com, a powerful trading resource designed to empower investors through knowledge. Founded by author and Super Trader George Fontanills, www.optionetics.com is dedicated to providing the resources necessary for successful option trading. Defined as the science of high profit and low stress trading, Optionetics works in virtually every market by taking advantage of market movement through focusing on volatility and limited risk spreads that maximize profits and reduce risk. By focusing on clear explanations of how to make money in the markets using options, the Optionetics methodology refrains from exposing investors to information that is overly theoretical or technically complicated. Contrary to widespread opinion, successful traders are not the gunslingers many people think they are-the most successful traders are risk managers. By learning to manage risk, traders can maintain positions with a higher probability of profitability. The use of Optionetics strategies in daily trading enables traders to accumulate positive trading experience and consequently build confidence in their decision-making abilities. Predefining the potentials for each trade helps traders determine when to take profits, cut losses, or add to a position to accelerate profits.

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