What About the Rest of the Market?

The financial headlines for much of the past two months have been all Dow, all the time. First, on October 3, 2006, the Dow Jones Industrial Average broke through its previous all-time high set in January 2000. A few weeks later, it surpassed 12,000, a milestone that is psychologically significant, mostly for being a round number.¹ Since then, the Dow has been in the headlines as it logs day after record-setting day.

Yet the S&P 500 and the Nasdaq stock indexes have yet to return to their record levels set in 2000. The reasons why may lie in the individual characteristics and limitations of these indexes and how investors view the companies they track.

American Backbone
The Dow Jones Industrial Average is the patriarch of stock indexes. The Dow, as it is often called, is the original stock market index, established in 1896 by journalist Charles Henry Dow in an attempt to help average investors track the market. The first Dow consisted of 12 industrial companies that produced such goods as rubber, steel, lead, coal, leather, sugar, tobacco, and fuels.² The index later expanded to 20 and then 30 companies as the stock market and the economy grew. Today, the word "industrial" is something of a misnomer. The companies in today's Dow represent almost every aspect of the U.S. economy, including entertainment, food and beverage, medical, pharmaceutical, retail, and oil, among other basic goods and services.

The companies tracked by the Dow are called "blue-chip" stocks because they tend to be big, well-established, stable corporations that generally make up the backbone of the U.S. economy. Most of the companies in the Dow are household names.

The relatively staid, conservative makeup of the Dow may explain why it was the first major index to return to its former highs. Although the U.S. economy has grown steadily since a brief recession in 2001, stock market investors have been on a bumpier road and thus may be looking for stability rather than growth.

The Younger Siblings
The Standard & Poor's 500 was officially established in 1957 but has roots that reach even deeper into the 20th century.³ As the name indicates, this index tracks 500 large-cap companies that are selected to represent the broader stock market. In fact, some market watchers see the S&P 500 as a bellwether for the entire U.S. economy. Many of the companies tracked in the S&P 500 are established and familiar, but some others are not.

The Nasdaq Composite Index, an upstart compared with the S&P and the Dow, tracks about 4,000 companies, ranging from the well-established to the fledgling start-up. The Nasdaq has a tendency to be somewhat more volatile than its two older siblings and includes many companies in the technology field.

Calculation Variation
It's critical to remember that stock market indexes play an important role, but they are also subject to limitations.

First, it's not possible to invest directly in any index. Indexes measure the historical performance of a select group of companies. They are useful for identifying market trends and permit comparisons with other periods in history, but they don't reveal details about the companies they track. It's prudent to select stocks with an eye toward promising long-term performance based on certain fundamentals that may or may not be subject to market trends.

Second, past performance is not a guarantee of future results. Any decisions based solely on index performance are reactionary rather than proactive.

Third, indexes are subject to certain biases that are inherent in statistical calculations. For example, the S&P 500 and the Nasdaq weight companies based on their total market value. This means that the greater a company's market value, the greater influence it has on the overall index performance. This is why you will often hear that a particular index was down on a given day because one or two companies had a bad day, despite the fact that other smaller stocks may have done well. By contrast, the Dow is a price-weighted average that gives higher-priced stocks more influence over the average than lower-priced stocks.

Stock market indexes serve investors in important ways, but placing too much emphasis on them can be deceptive. It's always good news to hear that an index set a record high, but it's empty news unless it helps your own portfolio follow suit.

1) Yahoo! Finance for the period January 1, 2000, to November 17, 2006. The performance of an unmanaged index is not indicative of the performance of any particular investment. Individuals cannot invest directly in an index. Past performance is no guarantee of future results.
2) Dow Jones & Company
3) InvestorWords.com

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