Pulling Back the Curtain on Stock Indices

Most people look to an index when following the health and trajectory of the stock market. However, all indices are not created equal and can lead to very different pictures of the health of an economy. Let’s look at how some of the major US indices are constructed and the pictures they are painting.

Charles Dow created the Dow Jones Industrial Average in 1896 with his partner Edward Jones as one of the first indices to track the US stock market. He chose 12 large industrial companies as a proxy of the broader economy. Over the years, changes were made as the index went from 12 to 30 companies, but the calculation remained constant. Dow took the sum of all the stock prices in the index each day and divided it by the “Dow Divisor.” As companies were added or removed from the index or as stocks split, the divisor was modified to maintain a consistent level in the index. The divisor, which can be found in the Wall Street Journal, is currently 0.14744568353097. 

Today, the Dow Jones Industrial Average (the Dow) is a relatively inadequate representation of the overall US stock market for two principal reasons. First, only 30 companies chosen by committee are used to represent the entire US stock market of over 4,000 listed companies. Second, the price of the stock determines what impact the company has on the index. As an illustration of this limitation, Pfizer is a company with a $214 billion market capitalization (share price multiplied by shares outstanding) with a stock price of $38.56. UnitedHealth Group is a company with a $290 billion market cap but a market price of $306.71. Even though these companies are similar in size and operate in related industries, UnitedHealth Group’s stock has nearly 8 times the impact on the Dow Jones Industrial Average on any given day as Pfizer simply due to its’ share price.  While the Dow is the perhaps the most widely quoted US stock market index, it is less representative of what is happening across markets and the economy and is heavily skewed by the highest priced stocks. 

Dow Jones Industrial Average (INDU)

Standard & Poor’s was created by the merger of Standard Statistics Company and Poor’s Publishing in 1941. In 1923, Standard Statistics developed its’ first stock market index of 233 companies that it tracked on a weekly basis. In 1957, the index was expanded to 500 companies and tracked daily. Standard & Poor’s looked to build a better representation of the US stock market by weighting the 500 companies based upon market capitalization. The larger the company’s market capitalization, the greater the weight in the index and vice versa. 

While a more sophisticated representation of the US stock market, the S&P 500 has its shortcomings. Specific criteria govern the inclusion of companies in the S&P 500, but like the Dow Jones Industrial Average, companies are added to the index via a committee. In addition, weighting companies in the index by market capitalization has its disadvantages. The very largest companies in the US have an extreme impact on the overall index movements. Microsoft, which is in the top three of market capitalization, has more than six times the impact of the 15th largest company Intel and more than 164 times the impact of the 400th largest company Baker Hughes. The six largest companies in the S&P 500 Index now account for more than 25% of the Index, the highest concentration since 1999. Through June 30th, the S&P 500 Index had fallen 4.04% in 2020.

S&P 500 Index (SPX)

When you remove the market capitalization weighting in the S&P 500, turning it into and equal weight index, a broader picture of the market appears that is less robust. Despite the sharp bounce off the lows in March, just under half of all companies in the S&P 500 remain below their 200 day moving averages (a broad measure of the long-term trend). And while the S&P 500 lost 4.04% through June 30th, the equal weight S&P 500 Index has lost more than 11.77%. Strong price moves in the largest companies can obfuscate the experience of the broader market. 

S&P 500 Equal Weighted Index (SPW) / Percent of Constituents Above the 200 Day MA

While stock indices play an important role in understanding markets and their current trajectory, it pays to look a little deeper to determine what is really happening. On the surface, things can look rosy while market internals may in fact be painting a very different picture. Historically, sustained bull markets in stocks require broad participation, a characteristic which is absent from the current advance. Next time the newscaster reports on the Dow Jones Industrial Average, take it with a grain of salt.