I Don’t Understand The Stock Market: Indexes

People say that this is a shift from growth to value that will continue throughout the year. Investors are selling their high flyers and trying to go somewhere safe. Some tech stocks have dropped 20%+, while the S&P 500 is at an all-time high.

How can stocks like Twilio have such wild swings while the indexes we are trained to follow show different patterns?

Understanding the Indexes

Dow Jones Industrial Average (^DJI)

Here’s an index that only includes 30 companies. These companies can change too. For instance, Apple recently split 4-1 and forced the Index to add Salesforce and remove other companies to keep the index balanced.

It’s also price-weighted. The higher the stock price, regardless of its market capitalization, the more influence the company has on the index. For example, Goldman Sachs trades ~$325 with a market cap of ~$110B. Meanwhile, Apple trades at ~$120 with a market cap of ~$2T. A company that is 18 times smaller is weighted three times as much.

Only 5 of the top 10 stocks by market capitalization are represented in ^DJI. Technology stocks are significantly underrepresented even though they make up a considerable portion of the total market. This could, of course, be interpreted as the sector being overvalued.

^DJI’s only value is age. We can easily look at historical data pre-1900, but I prefer not to care about 30 arbitrary companies’ price-based performance.

Nasdaq (^IXIC)

There are two major stock exchanges in the United States, the New York Stock Exchange (NYSE) and the Nasdaq. The NYSE is about twice as large from a market capitalization standpoint. The Nasdaq was more recently created in 1971 and has a heavier weight of technology stocks. Therefore ^IXIC is often used to get a sense of technology performance.

The Nasdaq Index is based on the company’s market capitalization. Therefore when you look at the Nasdaq Index, you are getting a true sense of the entire Nasdaq market. Unfortunately, this can hide some trees in the forest.

The Nasdaq has a market capitalization of approximately $17 Trillion. Unfortunately, if you take only the top 6 companies (Apple, Microsoft, Amazon, Google, Facebook, and Tesla), you account for half of the entire Nasdaq. The next 20 take up another 20%, and the top 100 accounts for well over 90% of the composite.

As long as these large companies continue to be too big to fail, their performance will hide possible under-production of smaller market capitalization companies. Also, newer technology companies have gone to the NYSE, and therefore this is not even a true “tech” index.

The S&P 500

First fun fact, the S&P 500 is actually 506 stock symbols.

Also, this isn’t a list of the 500 largest companies. For example, GAP is part of the S&P 500 and has a market capitalization of ~$11B. Meanwhile, companies like Twilio (~$50B), Square (~$100B), and Berkshire Hathaway’s A Shares(~$500B) are omitted.

Although it includes many more companies than the Dow Jones, the top 10 companies still account for over a quarter of the index. In my opinion, this is the only index worth much.

How is the Market Realing Performing?

I don’t love any of these indexes. S&P 500 is solid, but it’s still only 70-80% of the total U.S. Market.

You could track something like the Wilshire 5000, which gives a greater sense of the total market. I invest in FZROX, a fee-free total market mutual fund from Fidelity. I feel its performance is the best thing to compare my individual stock investments to.

There are many other indexes out there, and if you’re really trying to do individual stock buying, you need to compare your companies performance to its peers. However, then you still need to look outside to see if your thesis is still valid and the total market isn’t outperforming you (it probably is).

TheStreet tackled something that bothers me last year. They excluded the Top 10 companies from the S&P 500, and you can see how poorly the rest of the index performed. It makes you think about whether people keep buying the same large companies because everyone else does and are seen as safe because of how large they are.

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