Which stock index should you follow?
Whether it's the Dow Jones industrial average, the Nasdaq stock market, Standard & Poor's 500 index or the Russell 2000, investors use these popular indexes to get a sense of how the overall market is doing.
But these indexes aren't created equally. The Dow Jones, Nasdaq and Russell 2000 will only give you a glimpse into certain areas of the stock market while the S&P will provide a broader snapshot of market, although it's mainly for large- to medium-sized companies.
"The S&P 500 is the best barometer because it represents close to 80% of the market cap of all stocks publicly traded," says Jerry Harris, president of Sterne Agee Asset Management in Birmingham, Ala.
Often, investors will assume a high-flying stock market translates into a booming economy, but that isn't always the case. The stock market is typically driven by company news, economic data, and rumors and speculation. On the other hand, the economy is driven in part by the number of jobs and workers' paychecks -- not by whether Apple will come out with a new iPhone.
But what the different indexes can do is give investors a sense of certain industries, company sizes and the performance of that market grouping. Here's a look at how each of the major indexes stack up as indicators of overall stock market performance.
4 stock indexes and their market clout
The Dow Jones industrial average is one of the oldest stock indexes, dating back to the late 1800s. It's made up of 30 large U.S. companies that are publicly traded. Some of the companies included in the Dow Jones industrial average are American Express Co., Caterpillar Inc., Exxon Mobil Corp., General Electric Co. and Bank of America Corp.
While the stock index is comprised of large U.S. companies, the fact that it only encompasses 30 companies is one reason some analysts say it's flawed.
"Can 30 companies give an accurate barometer?" says Jared Levy, a stock strategist at Chicago-based Zacks Investment Research. "The lack of diversity is probably the No. 1 reason the Dow is a flawed index."
But, it doesn't stop there. The Dow is weighted based on the stock price of a company, not its size. Because of that, the Dow could be up a lot, but it could only be because one issue with a high stock price is moving that day. Take Peoria, Ill.-based construction and mining equipment maker Caterpillar, which trades at more than $100 per share. If Caterpillar had a bad earnings report and shares fall 5%, it could drive the entire Dow down, even though it's specific to Caterpillar and not the other stocks in the Dow.
While there is an index for the Nasdaq, the Nasdaq 100, investors tend to look at the Nasdaq National Market as a whole. Made up of close to 3,000 stocks, the Nasdaq is known for being a technology-heavy stock index, meaning lots of high-tech and biotech companies trade on the Nasdaq. In addition to tech stocks, lots of small-sized publicly traded companies list on the Nasdaq.
Paul Larson, an equities strategist at Chicago-based Morningstar Inc., says while it's broader than the Dow, it's a good indicator for only certain market sectors, not the overall market.
"In terms of small capitalization companies and tech, it's a bellwether," Larson says. Let's say you are investing only in tech stocks, how the Nasdaq is performing can give you an indication of how that sector is fairing. But if you are investing in oil companies, the Nasdaq won't be a good indicator of how that sector is doing.
Unlike the Dow, which is weighted by stock price, companies in the Nasdaq are weighted by size. That means companies such as Microsoft Corp., Google Inc. and Apple Inc. are going to get a heavier weighted value then small-cap stocks that trade for $1 per share.
By far the most diverse stock index, Standard & Poor's 500 index is made up 500 stocks of U.S. companies with a large market capitalization. The S&P 500 is one of the most followed stock indexes, which means there's a lot of information about the index and the stocks listed on it for investors to research.
"It's so heavily followed that there's so much information, it's easy to analyze," says Jared Levy, a stock strategist at Chicago-based Zacks Investment Research. "The S&P is the most accurate gauge of medium-to-large businesses in the U.S."
To be included in the S&P, a company has to meet certain criteria including size and market capitalization. What makes the S&P a better barometer of the stock market is its size compared to the Dow. That gives investors a much larger sample size than the Dow, says Paul Larson, an equities strategist at Chicago-based Morningstar Inc.
The Russell 2000 is the most widely used benchmark for mutual funds that invest in small-cap companies. It comprises the smallest 2,000 stocks in the Russell 3000. Just like Standard & Poor's 500 index is the most commonly analyzed index for large-cap stocks, the Russell is the most studied stock index for small-cap stocks.
The Russell 2000 also has more diversity than its counterparts given the sheer number of stocks included in the index, but because the companies included in the index are small, Paul Larson, an equities strategist at Chicago-based Morningstar Inc., cautions it may not be the best index to measure overall stock market activity.
"You are measuring smaller companies in earlier lifecycles which means more economic sensitivity," Larson says.
Although all of the stock indexes have their pros and cons, industry watchers say the best strategy when trying to gauge the performance of the stock markets is to take all four indexes into consideration.
"If you look at all (the indexes) and based on the movement of the stocks, you can certainly observe them closely to form an opinion of how the overall stock market is doing," says Jerry Harris, president of Sterne Agee Asset Management in Birmingham, Ala.